How Companies Can Use Transfer Pricing Strategies for Profit

Spare capacity
If there is spare capacity, then, for any sales that is made by using that spare capacity, the opportunity cost is zero. This is because workers and machines are not fully utilised. So, where a selling division has spare capacity the minimum transfer price is effectively just marginal cost. However, this minimum transfer price is probably not going to be one that will make the managers happy as they will want to earn additional profits. So, you would expect them to try and negotiate a higher price that incorporates an element of profit.

No spare capacity
If the seller doesn’t have any spare capacity, or it doesn’t have enough spare capacity to meet all external demand and internal demand, then the next question to consider is: how can the opportunity cost be calculated? Given that opportunity cost represents contribution foregone, it will be the amount required in order to put the selling division in the same position as they would have been in had they sold outside of the group. Rather than specifically working an ‘opportunity cost’ figure out, it’s easier just to stand back and take a logical approach rather than a rule-based one.

Logically, the buying division must be charged the same price as the external buyer would pay, less any reduction for cost savings that result from supplying internally. These reductions might reflect, for example, packaging and delivery costs that are not incurred if the product is supplied internally to another division. It is not really necessary to start breaking the transfer price down into marginal cost and opportunity cost in this situation.

It’s sufficient merely to establish:
(i) what price the product could have been sold for outside the group
(ii) Establish any cost savings, and
(Iii) Deduct (ii) from (i) to arrive at the minimum transfer price.

We have assumed here that production constraints will result in fewer sales of the same product to external customers. This may not be the case; perhaps, instead, production would have to be moved away from producing a different product. If this is the case the opportunity cost, being the contribution foregone, is simply the shadow price of the scarce resource.

In situations where there is no spare capacity, the minimum transfer price is such that the selling division would make just as much profit from selling internally as selling externally. Therefore, it reflects the price that they would actually be happy to sell at. They shouldn’t expect to make higher profits on internal sales than on external sales.

Maximum transfer price
When we consider the maximum transfer price, we are looking at transfer pricing from the point of view of the buying division. The question we are asking is: what is the maximum price that the buying division would be prepared to pay for the product? The answer to this question is very simple and the maximum price will be one that the buying division is also happy to pay.

The maximum price that the buying division will want to pay is the market price for the product – i.e. whatever they would have to pay an external supplier for it. If this is the same as the selling division sells the product externally for, the buyer might reasonably expect a reduction to reflect costs saved by trading internally. This would be negotiated by the divisions.

No external market for the product being transferred
Sometimes, there will be no external market at all for the product being supplied by the selling division; perhaps it is a particular type of component being made for a specific company product. In this situation, it is not really appropriate to adopt the approach above. In reality, in such a situation, the selling division may well just be a cost centre, with its performance being judged on the basis of cost variances. This is because the division cannot really be judged on its commercial performance, so it doesn’t make much sense to make it a profit centre. 

Summary
It’s important to understand why transfer pricing both does and doesn’t matter and it is important to be able to work out a reasonable transfer price/range of transfer prices. The thing to remember is that transfer pricing is actually mostly about common sense. You don’t really need to learn any of the specific principles if you understand what it is trying to achieve: the trading of divisions with each other for the benefit of the company as a whole. If the scenario in a question was different, you may have to consider how transfer prices should be set to optimise the profits of the group overall. Here, it was not an issue as group policy was that the two divisions had to trade with each other, so whether this was actually the best thing for the company was not called into question.

Price is the value that is put to a product or service and is the result of a complex set of calculations, research and understanding and risk taking ability. A pricing strategy takes into account segments, ability to pay, market conditions, competitor actions, trade margins and input costs, amongst others. It is targeted at the defined customers and against competitors.

There are several pricing strategies:
Premium pricing: high price is used as a defining criterion. Such pricing strategies work in segments and industries where a strong competitive advantage exists for the company.
Penetration pricing: Price is set artificially low to gain market share quickly. This is done when a new product is being launched. It is understood that prices will be raised once the promotion period is over and market share objectives are achieved.

Economy pricing: no-frills price. Margins are wafer thin; overheads like marketing and advertising costs are very low, Targets the mass market and high market share.

Skimming strategy: high price is charged for a product till such time as competitors allow after which prices can be dropped. The idea is to recover maximum money before the product or segment attracts more competitors who will lower profits for all concerned. Example: the earliest prices for mobile phones, VCRs and other electronic items where a few players ruled attracted lower cost.

Dr. Dada. MBA, PhD CPF Acct. is a Finance / Management Consultant and Certified Forensic Accountant ([email protected]; 08052043855).