Negotiated Transfer Prices

Negotiated Transfer Prices

Negotiated transfer- prices result from a bargaining process between selling and buying subunits. Consider again a transfer price between the Transportation and Refining divisions of
Horizon Petroleum. The Transportation Division has unused capacity it can use to transport oil from Matamoros to Houston. The Transportation Division will only purchase oil from Gulfmex and sell oil to the Refining Division if the transfer price equals or exceeds $17 per barrel of crude oil that‘s its variable cost. The Refining Division will only buy crude oil from the Transportation Division if the price does not exceed $21 per barrel-that‘s the price at which the Refining Division can buy crude oil in Houston.
From the perspective of Horizon Petroleum as a whole, operating income is maximized if the Refining Division purchases crude oil from the Transportation Division rather than from the Houston market (incremental cost per barrel of $17 versus $21). Both divisions would be interested in transact-ing with each other (thereby achieving goal congruence) if the transfer price is set between $17 and $21. For example, a ‗transfer price of $19.25 per barrel will increase the Transportation Division‘s operating income by $19.25 – $17 = $2.25 per barrel. It will increase the Refining Division‘s operating income by $21 – $19.25 = $1.75 per barrel because the Refining Division can now buy the crude oil for $19.25 internally rather than for $21 in the outside market.
Where between $17 and $21 will the transfer price per barrel be set? Under a negotiated transfer price, the answer depends on several things: the bargaining strengths of the two divisions; the information the Transportation Division has about the demand for its services from outside refineries; and the information the Refining Division has about its other available sources of crude oil. Negotiations become particularly, sensitive because Horizon Petroleum can now evaluate each division‘s performance on the basis of division operating income. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or market price. But cost and price information are often useful starting points in the negotiation process. A negotiated transfer price strongly preserves division autonomy because the transfer price is the outcome of negotiations between division managers. It also has the advantage that each division manager is motivated to put forth effort to increase division operating income. Its disadvantage is the time and energy spent on the negotiations.

A General Guideline for Transfer pricing Situations

The exhibit given summarizes the properties of the different transfer-pricing methods using the criteria described in this chapter the exhibit indicates, there is no transfer-pricing method that meets all the criteria. Market conditions, the goal of the transfer-pricing system, and the criteria of goal congruence, management effort, subunit performance evaluation, and subunit autonomy (if desired)must all be considered simultaneously. The transfer price a company will eventually Choose depends on the economic circumstances and the decision at hand. The following general guideline (formula) is a helpful first step in setting a minimum transfer price in many situations:
Minimum Transfer Price =Incremental cost per unit opportunity cost per unit
Incurred up to the point + to the selling subunit

Incremental Cost

Incremental cost in this context means the additional cost of producing and transferring the products or services. Opportunity cost here is the maximum contribution margin forgone by the selling subunit if the products or services are transferred internally. For example, if the selling subunit is operating at capacity, the opportunity cost of transferring a unit internally rather than selling it externally is equal to the market price minus variable cost. That‘s because by transferring a unit internally, the subunit forgoes .the contribution margin it could have obtained by selling the unit in the outside market. We distinguish incremental cost from opportunity cost because the financial accounting system typically records incremental cost but not opportunity cost. The guideline measures a minimum transfer price because the selling subunit will be motivated to sell the product to the buying subunit only if the transfer price covers the incremental cost the selling subunit incurs to produce the product and the opportunity cost it forges by selling the product internally rather than in the external market.
We illustrate the general guideline in some specific situations using data from Horizon Petroleum.
1. A perfectly competitive market for the intermediate product exists, and the selling division has no idle capacity. If the market for crude oil in Houston is perfectly competitive, the Transportation Division can sell all the crude oil it transports to the external market at $21per barrel, and it will have no idle capacity. The Transportation. Divisions incremental cost is $13 pet barrel (purchase cost of $12 per barrel plus variable transportation cost of $1 per barrel) for oil purchased under the long-term contract or $17 per barrel (purchase cost of $16
plus variable transportation cost of $1 ) for oil purchased at current market prices from Gulfrnex. The Transportation Division‘s opportunity cost per barrel of transferring the oil internally is the contribution margin per barrel forgone by not selling the crude oil in the external market:-$S for oil purchased under the long-term contract (market price, $21, ,minus variable cost, $13) and $4 for oil purchased from Gulfrnex (market price, $21, minus variable cost, $17). In either case,
Minimum transfer price =
Incremental cost + Opportunity cost
Per barrel per barrel
= $13 + $8
= $21
or
= $17 + $4 = $21
The minimum transfer price per barrel is the market price of $21. Market-based transfer prices are ideal in perfectly competitive markets when there is no idle capacity in the selling division.
2. An intermediate market exists that is not perfectly competitive, and the selling division has idle capacity. In markets that are not perfectly competitive, capacity utilization can only be increased by decreasing prices. Idle capacity exists because decreasing prices is often not worthwhile- it decreases operating income.
If the Transportation Division has idle capacity, its opportunity cost of transferring the oil internally is zero because the division does not forgo any external sales or contribution margin from internal transfers. In this case,
Minimum transfer price per barrel =
Incremental cost per barrel =
$13 per barrel for oil purchased under the long- term contract,
or
$17 per barrel for oil purchased from Gulfmex in Matamoros
Any transfer price above incremental cost but below $21 – the price at which the Refining Division can buy crude oil in Houston – motivates the Transportation Division to transport crude oil to the Refining Division and the Refining Division to buy crude oil from the Transportation Division. In this situation, the company could either use a cost-based transfer price or allow
the two divisions to negotiate a transfer price between t hemselves.
In general, when markets are not perfectly competitive, the potential to influence demand and operating income through prices complicates the measurement of opportunity costs. The transfer price depends on constantly. Changing levels of supply and demand. There is not just one transfer price. Rather, a transfer-pricing schedule presents the transfer prices for various quantities supplied and demanded, depending on the incremental costs and opportunity cotsof the units transferred.
3. No market exists for the intermediate product.
This situation would occur for the Horizon Petroleum case if the crude oil, transported by the Transportation Division could be used only by the Houston refinery (due to, say, its high tar content) and would not be wanted by outside parties. Here, the opportunity cost of supplying crude oil internally is, zero because the inability to sell crude oil externally means no
contribution margin is forgone. For the Transportation Division of Horizon Petroleum, the minimum transfer price under the general guideline is the incremental cost per barrel (either $13 or $17). As in the previous case, any transfer price between the incremental cost and $21 will achieve goal congruence.