Transfer Pricing

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149

Control w it h
fairness
in transfer pricing

A transfer price is useless
unless unit managers feel
they are being treated fairly
while top management
retains control

Robert G. Eccles

It seems straightforward on the face of it:
when a unit in a company sells a product
to another unit, it ought to charge a fair
price. That price may be based on what it
cost to make the product, or on the market
price of the product, or on some combination of these two. But as most managers involved in setting the transfer price know,
it is hard to define a price that both buyer
and seller see as fair.
After studying numbers of companies and
their transfer pricing policies, the author of
this article concluded that what makes a
transfer pricing policy work is an effective
management process whereby top management monitors the interaction between the units and alters the transfer pricing
policy to reflect changes in strategy. This
holds true in vertically integrated companies where cooperation and mutuality are emphasized as well as in diversified
companies, where each manager is out to
increase his or her ovm profits.
Mr. Ecclesis an assistant professor of hoth
business policy and organizational behavior at the Harvard Business School. This article is based on four years of research,
the results of which will be published in a
forthcoming book.

Imagine the following conversation in a
company president's office. He is talking with the general manager of a division selling products internally (seller), the general manager of a division buying these
products (buyer), and a professor who has read everything that has ever been written about transfer pricing.
President: I wish somebody could tell
me once and for all how we should do our transfer pricing. All the methods we've tried have problems, and often both the buyer and the seller claim they're being
treated unfairly.
Professor: The answer is really very
simple. When the product of the selling division is sold
in a perfectly competitive market, the buying division
should pay market price, with perhaps a discount to
recognize that selling costs and other such expenses
are saved on internal transactions. The buyer should be
free to obtain this product either internally or from
external suppliers.
Seller: That's a pretty fair arrangement.
Of course, selling internally is usually more trouble
than selling extemally, so I don't think a discount is
appropriate. After all, the buyer treats me in ways he
wouldn't dare treat an outside supplier. He delays and
cancels orders and demands product with short lead
times. What's more, why should the company lose out
on profits by buying outside when I have spare
capacity?
Buyer: In tbe real world. Professor, there
are very few perfectly competitive markets. I don't
think market price is necessarily the best idea, although I agree that I should be free to buy from whoever I want. After all, my performance is measured by how well my business does. It isn't fair to hold me

Editor's note: AU reierentcs are listed
at the end of the ariicU-.

150

Harvard Business Review

November-December 1983

responsible for profits and then interfere with those
kinds of decisions. I can usually get better prices, sales
support, service, and technical cooperation from outside suppliers. Professor: Well, you're right that market
price isn't the best approach in imperfectly competitive markets. In that case the best method, when there is spare capacity, is to use marginal cost and require
that you buy inside. That'll maximize company profits.
President: That sounds good to me.
Buyer: Our accounting system doesn't
measure marginal costs, but if they're something like
variable costs, I think it's fair. The price will be so
much lower that I'll live with the inferior product and
service I'm used to getting.
Seller: You've got to be kidding! I have
fixed costs to pay for, and I should get a...
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