Negotiated Transfer Pricing


Negotiated Transfer Pricing:

Definition and Explanation of negotiated transfer pricing:

A negotiated transfer pricing results from discussions between the selling and buying divisions. Negotiated transfer prices have many important advantages.

 First, this approach preserves the autonomy of the divisions and is consistent with the spirit of decentralization. Second, the managers of the divisions are likely to have much better information. about the potential costs and benefits of the transfer than others in the company.

When negotiated transfer prices are used in the company, the managers who are involved in proposed transfer within the company meet to discuss the terms and conditions of the transfer. They may decide not to go through with the transfer, but if they do, they must agree to a transfer price. Generally speaking, we cannot predict the exact transfer price they will agree to. However we can confidently predict two things: (1) the selling division will agree to transfer only if the profits of the selling division increase as a result of the transfer, and (2) the buying division will agree to the transfer to the transfer only if the profits of the buying division also increase as a result of the transfer. This may seem obvious, but it is an important point.

Clearly, if the transfer price is below the selling division’s cost, a loss will occur on the transaction and the selling division will refuse to agree to the transfer. Likewise if the transfer price is set too high, it will be impossible for the buying division to make any profit on the transferred item. For any given proposed transfer, the transfer price has both a lower limit (determined by the situation of the selling division) and the upper limit (determined by the situation of the buying division). The actual transfer price agreed to by the two division managers can fall anywhere between these two limits. These limits determine the range of acceptable transfer prices–the range of transfer prices within which the profits of both divisions participating in a transfer would increase.

The selling division’s lowest acceptable transfer price:

If the transfer has no effect on fixed costs, then from the selling division’s standpoint, the transfer price must cover both the variable costs of producing transferred units and any opportunity costs.

Seller’s perspective:

Transfer price > Variable cost + (Total contribution margin of lost sales / Number of units transferred)

Buying division’s highest acceptable transfer price:

The buying division will be interested in the proposal only if its profit increases. In case, a buying division or segment has an outside supplier, the buying division’s decision is simple. Buy from the inside supplier if the price is less than the price offered by the outside supplier.

Purchaser’s perspective:

Transfer price < Cost of buying from outside suppliers

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

  1. Decentralization in organizations
  2. Traceable and common fixed costs
  3. Segment reporting and profitability analysis-segmented income statements
  4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
  5. Segmented Financial Information on External Reports
  6. Return on Investment (ROI) for Measuring Managerial Performance
  7. Controlling and Improving Rate of Return on Investment
  8. Return on Investment (ROI) and Balanced Scorecard
  9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
  10. Residual Income-Another Method to Measure Managerial Performance
  11. Limitations, Criticism or Disadvantage of Residual Income Method
  12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
  13. Set transfer prices at cost using variable or full (absorption) cost
  14. Set transfer prices at the market price
  15. Divisional Autonomy and Sub optimization
  16. International Aspects of Transfer Pricing

Definition and Explanation of negotiated transfer pricing:

A negotiated transfer pricing results from discussions between the selling and buying divisions. Negotiated transfer prices have many important advantages.

 First, this approach preserves the autonomy of the divisions and is consistent with the spirit of decentralization. Second, the managers of the divisions are likely to have much better information. about the potential costs and benefits of the transfer than others in the company.

When negotiated transfer prices are used in the company, the managers who are involved in proposed transfer within the company meet to discuss the terms and conditions of the transfer. They may decide not to go through with the transfer, but if they do, they must agree to a transfer price. Generally speaking, we cannot predict the exact transfer price they will agree to. However we can confidently predict two things: (1) the selling division will agree to transfer only if the profits of the selling division increase as a result of the transfer, and (2) the buying division will agree to the transfer to the transfer only if the profits of the buying division also increase as a result of the transfer. This may seem obvious, but it is an important point.

Clearly, if the transfer price is below the selling division’s cost, a loss will occur on the transaction and the selling division will refuse to agree to the transfer. Likewise if the transfer price is set too high, it will be impossible for the buying division to make any profit on the transferred item. For any given proposed transfer, the transfer price has both a lower limit (determined by the situation of the selling division) and the upper limit (determined by the situation of the buying division). The actual transfer price agreed to by the two division managers can fall anywhere between these two limits. These limits determine the range of acceptable transfer prices–the range of transfer prices within which the profits of both divisions participating in a transfer would increase.

The selling division’s lowest acceptable transfer price:

If the transfer has no effect on fixed costs, then from the selling division’s standpoint, the transfer price must cover both the variable costs of producing transferred units and any opportunity costs.

Seller’s perspective:

Transfer price > Variable cost + (Total contribution margin of lost sales / Number of units transferred)

Buying division’s highest acceptable transfer price:

The buying division will be interested in the proposal only if its profit increases. In case, a buying division or segment has an outside supplier, the buying division’s decision is simple. Buy from the inside supplier if the price is less than the price offered by the outside supplier.

Purchaser’s perspective:

Transfer price < Cost of buying from outside suppliers

You may also be interested in other articles from “decentralization, segment reporting and transfer pricing” chapter:

  1. Decentralization in organizations
  2. Traceable and common fixed costs
  3. Segment reporting and profitability analysis-segmented income statements
  4. Hindrances/Problems to Proper Cost Assignment in Segmented Reporting
  5. Segmented Financial Information on External Reports
  6. Return on Investment (ROI) for Measuring Managerial Performance
  7. Controlling and Improving Rate of Return on Investment
  8. Return on Investment (ROI) and Balanced Scorecard
  9. Criticism, Disadvantages or Limitations of Return on Investment (ROI)
  10. Residual Income-Another Method to Measure Managerial Performance
  11. Limitations, Criticism or Disadvantage of Residual Income Method
  12. Allow the managers involved in the transfer to negotiate their own transfer price (negotiated transfer pricing).
  13. Set transfer prices at cost using variable or full (absorption) cost
  14. Set transfer prices at the market price
  15. Divisional Autonomy and Sub optimization
  16. International Aspects of Transfer Pricing

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