An alternative cost-based approach is for Horizon Petroleum to choose a transfer price that splits, on some fair basis, the $4 difference between the $21 per barrel maximum transfer price the Refining Division is willing to pay and the $17 per barrel minimum transfer price the Transportation Division is willing to charge.Suppose Horizon Petroleum allocates the $4 difference on the basis of the budgeted variable costs of the Transportation Division and the Refining Division for a given quantity of crude oil. Using the data in Exhibit, the variable costs are as follows:
Transportation Division‘s variable costs to transport
100 barrels of crude oil – 100
Refining Division‘s variable costs to refine
100 barrels of crude oil and produce
50 barrels of gasoline – 400
Of the $4 difference in transfer prices ($21 – $17), the Transportation Division gets to keep ($100 + $500) x $4.00 = $0.80, and the Refining Division gets to keep ($400 + $500) x $4.00 = $3.20. That is, the transfer price between the Transportation Division and the Refining Division would be $17.80 per barrel of crude oil ($16 purchase cost + $1 variable cost + $0.80 that the Transportation Division gets to keep). This approach is a budgeted variable-cost-plus transfer price. The plus indicates the setting of a transfer price above variable cost.
To decide on the $O.8O and $3.20 allocation of the $4.00 contribution to total company operating income per barrel, the divisions must share information about their variable costs. In
effect, each division does not operate (at least for this transaction) in a totally decentralized manner. Because most organizations are hybrids of centralization and decentralization anyway, this approach deserves serious consideration when transfers are significant. Note, each division has an incentive to overstate its variable costs to receive a more-favorable transfer price.
There is seldom a single cost-based transfer price that simulta neously meets the criteria of goal congruence, management effort, subunit performance evaluation, and subunit autonomy. As a result, some companies choose dual pricing, using two separate transfer pricing methods to price each transfer from one subunit to another. An example of dual pricing arises when the selling division receives a full-costbased price and the buying division pays the market price for the internally transferred products. Assume Horizon Petroleum purchases crude oil from Gulfmexo in Matamoros at $16 per barrel. One way of recording the journal entry for the transfer between the Transportation Division and the Refining
1. Debit the Refining Division (the buying division) with the market-based transfer price of $21 per barrel of crude oil.
2. Credit the Transportation Division (the selling division) with the ll0% of full cost transfer price of $22 per barrel of crude oil.
3. Debit a corporate cost account for the $1 ($22 – $21) per barrel difference between the transfer prices.
The dual-pricing system promotes goal congruence because it makes the Refining Division no worse off if it purchases the crude oil from the Transportation Division rather than from the outside supplier at $21, per barrel. The dual-pricing system gives the Transportation Division a corporate subsidy. The effect of dual pricing is that the operating income for Horizon Petroleum as a whole is less than the sum of the operating incomes of the divisions.
Dual pricing is not widely used in practice even though it reduces goal incongruence associated with a pure cost-based transferpricing method. One concern with dual pricing is that it leads to problems in computing the taxable income of subunits located indifferent tax jurisdictions, such as in our example, where the Transportation Division is taxed in Mexico while the Refining Division is taxed in the United States. A second concern is that the manager of the supplying subunit does not have sufficient incentive to control costs with a dual-pricing system because the supplying division records revenues based on actual costs. A third concern is that dual pricing insulates managers from the frictions of the marketplace because costs, not market prices, affect the revenues of the supplying division.