Negotiated transfer prices

Perfectly competitive markets rarely exist. In most cases, producers can influence price (e.g., by being large enough to influence demand by dropping the price of the product or by selling closely related but differentiated products). When imperfections exist in the market for the intermediate product, market price may no longer be suitable. In this case, negotiated transfer prices may be a practical alternative. Opportunity costs can be used to define the boundaries of the negotiation set. Negotiated outcomes should be guided by the opportunity costs facing each division. A negotiated price should be agreed to only if the opportunity cost of the selling division is less than the opportunity cost of the buying division.

Example 1: Avoidable Distribution Costs
To illustrate, assume that a division produces a circuit board that can be sold in the outside market for $22. The division can sell all that it produces to the outside market at $22. If it does so, however, it incurs a distribution cost of $2 per unit. Currently, the division sells 1,000 units per day, with a variable manufacturing cost of $12 per unit. Alternatively, the board can be sold internally to the company’s recently acquired Electronic Games Division. The distribution cost is avoidable if the board is sold internally. The Electronic Games Division is also at capacity, producing and selling 350 games per day. These games sell for $45 per unit and have a variable manufacturing cost of $32 per unit. Variable selling expenses of $3 per unit are also incurred. Sales and production data for each division are summarized in Exhibit 10-3.

How could the Games Division and the Circuit Board Division set a transfer price? Let’s assume that the Games Division currently pays $22 per circuit board. Clearly, the Games Division would refuse to pay more than $22; thus, the maximum transfer price is $22. The minimum transfer price is set by the Circuit Board Division. While this division prices its circuit boards at $22, it will avoid $2 of distribution cost if it sells internally. Therefore, the minimum transfer price is $20 ($22 $2). If a bargaining range exists, the transfer price will fall somewhere between $22 and $20.

Suppose that the Game Division manager offered a transfer price of $20. That division would be better off by $2 per circuit board, since it had previously paid $22 per board. Its profits would increase by $700 per day ($2 350 units per day). The Circuit Board Division, on the other hand, would be no better, or worse, off than before and no incremental profit would accrue to the division. While a transfer price of $20 per circuit board is possible, it is unlikely that the Circuit Board manager would agree to it.

Now suppose that the Circuit Board Division counters with an offer of $21.10 per board. That transfer price allows the Circuit Board Division to increase its profits by $385 per day [($21.10 - $20.00) x 350 units]. The Games Division would increase its profits by $315 per day [($22 - $21.10) x 350 units]. While we cannot tell exactly where the Circuit Board Division and the Games Division would set a transfer price, we can see that it will be somewhere within the bargaining range. [The minimum transfer price ($20) and the maximum transfer price ($22) set the limits of the bargaining range.] Exhibit 10-4 provides income statements for each division before and after the agreement. Notice how the total profits of the firm increase by $182,000 as claimed; notice, too, how that profit increase is split between the two divisions. Read cost based transfer prices

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