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
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