Transfer Pricing in Divisionalised Organisations
Control
Transfer Pricing in Divisionalised Organisations
Syllabus tag: KASNEB CPA | Advanced Level | CA34S3 Advanced Management Accounting | Topic 6 Transfer Pricing in Divisionalised Organisations
Lesson objectives
By the end of this topic, you will be able to:
- State the objectives a transfer price must serve
- Compute the minimum and maximum acceptable transfer prices
- Show how a badly set price destroys group value
- Compare market-based, cost-based and negotiated methods
- Explain the international and taxation dimension
Why this matters
CA25 gave the general rule: minimum transfer price equals marginal cost plus opportunity cost. This topic asks what happens when the rule is ignored — and the answer is that autonomous managers acting rationally make the group worse off.
What a transfer price must achieve
Four objectives, and the difficulty is that they conflict:
- Goal congruence — decisions good for a division are good for the group
- Performance measurement — each division fairly judged
- Autonomy — managers free to decide, or divisionalisation is a fiction
- Motivation — managers accept the system as fair
A price imposed by head office achieves congruence and destroys autonomy. One left entirely to negotiation preserves autonomy and may destroy congruence. No method satisfies all four, and saying so is part of a complete answer.
The bargaining range
Minimum the supplying division will accept = marginal cost + opportunity cost.
Maximum the buying division will pay = the lower of the external purchase price and the net marginal revenue it can earn.
Worked example. The supplying division has variable cost KES 420 and fixed cost KES 180 per unit, and sells externally at KES 640. The buying division can buy the same component outside for KES 590.
| Circumstance | Minimum acceptable |
|---|---|
| Spare capacity | 420 — nothing is given up |
| Full capacity | 420 + (640 − 420) = 640 — an external sale is lost |
With spare capacity the range is 420 to 590, a width of KES 170. Any price in that range makes both divisions better off and the group gains 170 a unit.
At full capacity the minimum of 640 exceeds the buyer's maximum of 590. No transfer should occur — and correctly so, because the component is worth more sold outside.
How a bad price destroys value
Suppose head office sets the price at full cost plus 20%:
(420 + 180) × 1.20 = KES 720
The buying division refuses, because it can buy outside at 590. It acts rationally on the price it faces.
But with spare capacity, the group has just lost 590 − 420 = KES 170 a unit — the difference between paying an outsider 590 and incurring only 420 of real cost internally. On 8,000 units that is KES 1,360,000.
The fixed cost of 180 was not saved by buying outside; it continues regardless. Including it in the transfer price made a beneficial transfer look uneconomic.
This is the central example of the topic. Nobody behaved badly. The transfer price was wrong, and rational managers followed it into a worse outcome for the group.
:::checkpoint The supplying division argues it cannot transfer at 420 because it would show a loss after fixed costs. Explain why that argument is mistaken from the group's viewpoint, and suggest a mechanism that would satisfy both divisions. :::
Methods
| Method | Strength | Weakness |
|---|---|---|
| Market price | Objective; preserves autonomy | Needs a genuine external market; ignores savings on internal supply |
| Adjusted market price | Removes selling costs not incurred internally | Requires agreement on the adjustment |
| Marginal cost | Leads to correct group decisions | Supplying division makes no contribution to fixed costs |
| Full cost | Covers all costs | Encourages wrong decisions, as above |
| Full cost plus | Gives the supplier a margin | Compounds the same error |
| Negotiated | Preserves autonomy; often practical | Depends on bargaining skill, not economics |
| Dual pricing | Both divisions see a correct price | Group accounts need adjusting; can conceal inefficiency |
| Two-part tariff | Marginal cost per unit plus a fixed fee | Fee must be renegotiated as volumes change |
The two-part tariff deserves attention because it resolves the conflict directly. The buyer is charged marginal cost per unit, so its decisions are correct for the group. The supplier receives a periodic fixed fee covering its fixed costs and profit.
With a fee of KES 900,000 over 8,000 units:
Effective cost to the buyer = 420 + (900,000 / 8,000) = KES 532.50
Still below the external 590, so the transfer proceeds, and the supplying division is not left bearing its fixed costs unrewarded.
Dual pricing achieves the same end differently: the supplier is credited with the market price of 640 while the buyer is charged the marginal cost of 420, and the 220 difference is eliminated on consolidation.
The international dimension
Where divisions sit in different countries, transfer prices shift profit between tax jurisdictions, and a group has an obvious incentive to record profit where tax is lowest.
Tax authorities respond with arm's length rules requiring related-party transactions to be priced as they would be between independent parties, backed by documentation requirements and the OECD guidelines. Kenya applies transfer pricing rules through the Income Tax Act, as covered in CA26.
Other complications: exchange controls limiting remittance, customs duty which rises with the declared transfer price, and the risk of double taxation where two authorities disagree about the correct price.
The tension is worth naming. A transfer price that is optimal for internal decision making may be unacceptable to a tax authority, and a group frequently maintains one set of prices for management purposes and another, defensible on arm's length principles, for tax.
:::checkpoint A Kenyan manufacturing division supplies a distribution division in a low-tax jurisdiction. Explain the group's tax incentive, the constraint the authorities impose, and why the price used for internal performance measurement need not be the same figure. :::