Transfer Pricing- At What price?

The decision to transfer is not always based on the transfer price. Multree Homes realised this when one of its cost centre evolved into a profit centre

When one department of a company transfers goods to another department, within the company, then the price at which it transfers is known as the transfer price. There has been an ongoing debate on the amount to be charged for the transfer. Multree Homes ready-made home manufacturer faced a similar situation. Its window-making department based at Nevada emerged as its core competency. Nevertheless, it was treated as a cost centre. The manager of the department, however, considered it a profit centre. The evolution from a cost centre to a profit centre was thus a learning process.

Cost Centre
The CFO of the company did not subscribe to the manager's views. According to her, every department in a company should be treated as supplier to other departments (internal customers). Being a cost centre, it was obliged to control costs and maintain quality. The price at which the windows would be transferred would reflect the budgeted cost.

The performance of the department was evaluated on certain key accounting parameters, primarily the cost variances. Cost variance is the total cost incurred in resolving a particular problem.

Pseudo Profit Centre
Many managers opposed the policy since their departments contributed towards the value of the company. The window-making department, in particular, wanted to be treated as a profit centre. The request was considered. The management decided to treat it as a pseudo profit centre. Pseudo profit centre provide goods only to internal customers. However, these departments would report profits by transferring goods at a marked up price

Initially, the management decided on a transfer price, which would be marked 20% on actual cost. The results are shown in Table 1.

The windows were transferred to the assembly department at this price. Since this exceeded the actual cost, the department would be reporting a variance. Hence, the manager of the department and the CFO opposed the policy. The management, then, decided to fix the transfer price at 20% mark up on the budgeted price. Table 2 shows the results.

The manager of the window-making department opposed this policy. She felt that she could no longer motivate her staff to maintain quality and control costs. Neither did she agree that subordinates could be motivated if they are told that their departments were contributing to the profits. According her, the profits were reported only on paper.

The real profit centre
The resistance towards transfer pricing policies compelled the management to consider the window-making department as a profit centre. Though the department could sell its windows at the market place, its first priority would be supplying to the assembly department.

The transfer price, according to the CFO, in this scenario would have to cover all the costs of the department including the fixed costs. In other words, it should be transferred at the standard absorbed cost. This would amount to $120. The department could sell the excess capacity at the market to generate a surplus. Strategically, to achieve market penetration the department was allowed to sell at break-even rates.

Radical shift
Theoretically the best transfer price would be the market price. However, adoption of such a policy might result in some departments reporting variances. If on the other hand they were allowed to buy from outside suppliers, they could negotiate and procure the same at a lower price. This suggestion was accepted.

The profitable transfer price
It was found that there were no transfers from the window-making department to the assembly department. This was because the managers of the respective departments were not able to decide on a transfer price. The CFO, then, realised that the managers' decision to transfer depended on the transfer price. She felt that undue importance was given to the price. According to her, the decision to transfer should depend on the cash flow streams of the company and transfer price should be calculated only for profit sharing among departments.

She also opined that the rewards system influences transfer prices adversely. The system was based on the profits generated, through outside sales and transfers, by each of the departments. Hence managers, usually, are at a conflict when deciding on the transfer price.

To conclude…
Companies should, therefore, develop tools that would enable managers to determine the timing of transfers. The rewards system should be so developed to avoid conflicts and enable the development of an appropriate transfer pricing policy.

Related reading
The Multree Hones Transfer Pricing Evolution": M Thomas

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