Decentralisation pushes decision-making to division managers, which speeds things up and sharpens local focus, but risks suboptimal company-wide outcomes and duplicated information costs. Transfer pricing is the mechanism that sets the internal price when one division sells to another, and the method chosen (variable cost, full cost, or market price) directly changes each division's reported profit. The general guideline ties the minimum transfer price to incremental cost plus the supplying division's opportunity cost, which shifts depending on whether spare capacity exists.
Difficulty: Intermediate | Prerequisites: Basic understanding of cost accounting, contribution margin, and divisional structures.
Chapter 22 sits at the intersection of organisational design and internal accounting. Once a firm grows large enough to split into divisions, two questions arise: how much autonomy should each division have, and how should internal transactions between divisions be priced? The answers directly affect managerial incentives, reported divisional profits, and whether the company as a whole makes optimal decisions.
If you have been following cost-volume-profit analysis and contribution margins, this chapter applies those tools inside the firm, between divisions rather than between a firm and its customers. You should already be comfortable with variable vs. fixed costs, contribution margin per unit, and the idea that opportunity cost is the profit forgone by choosing one alternative over another.
Decentralisation
The delegation of decision-making authority from top management to the managers of subunits (divisions, departments, regions). Think of it as giving each division its own steering wheel rather than having head office drive everything.
Subunit / Division
A distinct segment of a larger organisation, often treated as a profit centre or investment centre. In simple terms, it is a part of the company that is measured on its own financial results.
Transfer price
The price one subunit of a company charges another subunit for a product or service supplied internally. Think of it as the "invoice" that one sibling division sends to another.
Variable-cost transfer pricing
Setting the transfer price equal to the variable cost per unit of the supplying division. In simple terms, the buying division pays only the out-of-pocket production cost, nothing for overheads or profit.
Full-cost transfer pricing
Setting the transfer price equal to the full (absorption) cost per unit, including allocated fixed costs. In simple terms, the buying division pays the total average cost of making the product, but the selling division earns no margin.
Market-price transfer pricing
Setting the transfer price at the price the product could fetch on the open market. Think of it as treating the internal sale the same as a sale to an outside customer.
Contribution margin (CM)
Selling price minus variable costs per unit. In simple terms, the amount each unit sold contributes toward covering fixed costs and generating profit.
Opportunity cost (in transfer pricing)
The contribution margin per unit the supplying division forgoes by transferring internally rather than selling externally. If the division has spare capacity and no outside buyer for those units, the opportunity cost is zero.
Minimum transfer price (general guideline)
Incremental cost per unit up to the point of transfer, plus the opportunity cost per unit to the supplying division. This is the floor below which the supplying division is worse off transferring internally.
Maximum transfer price
The price the buying division would pay on the outside market for the same product (including any additional purchasing costs). This is the ceiling above which the buying division would simply buy externally.
Negotiated transfer price
A transfer price agreed upon between the managers of the supplying and buying divisions, typically falling between the minimum and maximum. "Split the difference" is one common negotiation rule.
Weighted average external price
An average selling price computed across all external customers, weighted by the volume sold to each. Used when a division sells to multiple external buyers at different prices.
Three benefits of decentralisation
Faster decision-making: division managers are closer to local conditions (customers, suppliers, production issues) and can respond without waiting for head-office approval.
Higher motivation: managers who control their own results tend to be more engaged and accountable.
Sharper focus: each manager concentrates on the specific operations they oversee, developing deeper expertise in their segment.
Two costs of decentralisation
Higher information-gathering costs: each division may duplicate data collection that a centralised function would handle once.
Subunit tunnel vision: managers optimise their own division's results, sometimes at the expense of the company as a whole. This is the root cause of most transfer-pricing conflicts.
The three main methods produce very different divisional profit figures, even though the company-wide total may be the same.
Variable-cost method: the supplying division transfers at its variable cost per unit. The supplying division shows zero contribution margin on internal sales; all the margin flows to the buying division. This tends to make the supplying division look unprofitable.
Full-cost method: the supplying division transfers at full absorption cost. The supplying division breaks even on internal sales (covering all costs but earning no profit), and the buying division's cost is higher than under variable cost.
Market-price method: the supplying division transfers at the external market price. Each division's reported income mirrors what it would earn dealing with outsiders. This method best preserves divisional autonomy but only works when a competitive external market exists.
The key exam point: these methods do not give the same division operating income. They shift profit between the supplying and buying divisions. Company-wide income is unaffected only if the transfer does not change the total volume of production and sales.
The formula is:
\text{Minimum TP} = \text{Incremental cost per unit} + \text{Opportunity cost per unit to the supplying division}This guideline adapts to capacity:
Supplying division has excess capacity: opportunity cost is zero (no outside sale is sacrificed), so the minimum transfer price equals the variable (incremental) cost per unit.
Supplying division is at full capacity: every unit transferred internally displaces an external sale, so the opportunity cost equals the lost contribution margin per unit. The minimum transfer price therefore equals variable cost plus contribution margin, which works out to the external selling price.
The buying division will pay up to the external purchase price (including any extra purchasing costs such as freight or inspection). The feasible range for negotiation sits between the supplying division's minimum and the buying division's maximum.
Full-cost transfer prices include allocated fixed costs, which means the buying division sees a per-unit cost that does not reflect the incremental cost of producing one more unit. This can lead to suboptimal decisions for the company:
The buying division may refuse a transfer that would be profitable company-wide because the full-cost price makes the deal look unattractive.
The supplying division has little incentive to control costs, since all costs are simply passed through.
If the allocation base changes (e.g. volume drops), the per-unit full cost rises, potentially triggering a "death spiral" where the buying division buys even less.
\text{Contribution Margin per unit} = \text{Selling price} - \text{Variable cost per unit}\text{Minimum Transfer Price} = \text{Incremental cost per unit} + \text{Opportunity cost per unit}\text{Split-the-difference price} = \frac{\text{Min TP (supplying)} + \text{Max TP (buying)}}{2}\text{Weighted Average External Price} = \frac{\sum (\text{Quantity}_i \times \text{Price}_i)}{\sum \text{Quantity}_i}Transfer pricing is central to multinational corporations, where divisions in different countries trade with each other. Tax authorities scrutinise these prices because shifting profits to low-tax jurisdictions reduces a company's overall tax bill. The OECD's arm's-length principle essentially mirrors the market-price method.
Within a single country, transfer pricing still matters operationally. A car manufacturer whose engine division charges the assembly division at full cost may discourage internal sourcing, pushing the assembly division to buy engines from a competitor, even when the company would be better off keeping production in-house.
Students often think all transfer-pricing methods produce the same divisional income. They do not. Only company-wide income stays the same (and only when the method does not change total volume).
Students confuse incremental cost with full cost when applying the general guideline. The minimum transfer price starts from incremental (usually variable) cost, not absorption cost.
Students sometimes assume opportunity cost is always zero when excess capacity exists. It is zero only for the units that cannot be sold externally. If the division can sell some units outside, those units still carry an opportunity cost.
Students forget that the maximum transfer price is set by the buying division's outside alternative, not by any internal cost figure.
The benefits and costs of decentralisation are a common short-answer question. Know three benefits and two costs cold.
Expect a question asking whether all transfer-pricing methods yield the same divisional income. The answer is no, with a brief explanation of why.
The general guideline formula (incremental cost + opportunity cost) is the workhorse of exam problems. Be ready to apply it in two scenarios: excess capacity (opportunity cost = 0) and full capacity (opportunity cost = CM per unit).
Full-cost limitations are frequently tested as a "what could go wrong" question. The core answer: suboptimal company-wide decisions.
Negotiated transfer pricing questions often ask you to identify the feasible range and apply a "split the difference" rule.
True or false: decentralisation always reduces information-gathering costs. (False: it typically increases them.)
Fill in the blank: the minimum transfer price under the general guideline equals incremental cost plus ______. (opportunity cost per unit to the supplying division)
True or false: when the supplying division has excess capacity, its opportunity cost of transferring internally is zero. (True, for the units that have no outside buyer.)
True or false: full-cost transfer pricing can lead to suboptimal decisions for the company as a whole. (True.)
Fill in the blank: the maximum transfer price is determined by the ______ division's outside purchasing alternative. (buying)
Q: Name three benefits and two costs of decentralisation.
A: Benefits: (1) faster decision-making, (2) increased motivation for subunit managers, (3) sharper managerial focus. Costs: (1) higher information-gathering costs, (2) managers may focus on their own subunit at the expense of the company as a whole.
Q: Do all transfer-pricing methods give the same division operating income? Explain.
A: No. Variable-cost, full-cost, and market-price methods allocate profit differently between the supplying and buying divisions. For example, variable-cost pricing gives all the margin to the buying division, while market-price pricing lets the supplying division keep the same margin it would earn selling externally.
Q: What is one potential limitation of full-cost-based transfer prices?
A: They can lead to suboptimal decisions for the company as a whole, because the buying division sees a cost that includes fixed-cost allocations rather than the true incremental cost of production.
Q: Under the general guideline, does the minimum transfer price change depending on whether the supplying division has unused capacity? Explain.
A: Yes. The minimum transfer price equals incremental cost plus opportunity cost. When the supplying division has unused capacity, opportunity cost is zero, so the minimum is just the incremental (variable) cost. When the division is at capacity, every unit transferred displaces an external sale, so the opportunity cost equals the lost contribution margin, raising the minimum transfer price.
Q: Division S produces a component at a variable cost of $40 and sells it externally for $60. Division B can buy the same component from an outside supplier for $58. Division S is at full capacity. What is the minimum transfer price? Should the transfer occur?
A: Minimum TP = $40 (incremental cost) + $20 (opportunity cost, i.e. $60 - $40 contribution margin forgone) = $60. The buying division's maximum is $58. Since $60 > $58, the transfer should not occur; the company is better off having Division S sell externally and Division B buy from the outside supplier.
This material connects to responsibility accounting (Chapter 23 in most textbooks), where divisions are evaluated as cost centres, profit centres, or investment centres. The transfer price directly affects divisional profit and therefore the ROI and residual income metrics used to evaluate managers.
It also ties back to cost-volume-profit analysis: the contribution margin concept used to compute opportunity cost is the same CM from earlier chapters, just applied inside the firm rather than to external sales.
Goal congruence, the idea that divisional incentives should align with company-wide objectives, is the thread running through both decentralisation and transfer pricing. When the transfer price is set poorly, goal congruence breaks down.
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