Academic and Western: Cost Allocation as Transfer Pricing

For arriving at the transfer price between Academic and Western, a negotiated transfer pricing is the best method. Negotiated transfer pricing needs a bargaining process between Academic and Western. Academic should ensure that the overheads are met and some contribution is made towards the fixed expenses. Western should be happy so long as it has to pay a price less than the full charge and the profit is more than that it can derive if it gets the job done at full price. However, Western cannot think of using the outside service and earn a profit of $ 180, because if it chooses to use outside laboratory, then Academics will lose $ 90 and the net effect is that the institution earns $ 90 as profit in total, which is not advisable. This is not acceptable from the point of view of Academics also.

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The same is the situation, if the market price is applied, as in this case also Academic stands to lose $ 15, which is not effective from the institution’s point of view.

Therefore, a negotiated transfer price is the only way the price for the service can be fixed. Generally, it is not possible to arrive at exact transfer price that the hospitals would agree. However, there are two things, which are certain in the case of fixation of transfer prices. They are: “(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.” (Accounting for Management, 2008)

If the transfer price is less than the cost of Academic a loss will occur on rendering the service to Western and therefore Academic may refuse to accept a price, which is less than its cost. On the other hand, if the transfer price is fixed at a higher level, then Western may not agree to such a price, as it cannot make a profit on the transaction. Therefore the transfer price can lie anywhere between $ 400 and $ 425 to be decided by the negotiation between the mangers of the hospitals. The effect of these transfer prices are shown in the following table:

Approach Transfer Price Academic’s Profit Western’s Profit Combined Profit
1. Full Charge $ 450 $ 60 $ 105 $ 165
2. Variable Cost $ 300 $ – 90 $ 255 $ 165
3. Market Price $ 375 $ – 15 $ 180 $ 165
4. Negotiated Price – 1 $ 400 $ 10 $ 155 $ 165
4. Negotiated Price – 2 $ 425 $ 35 $ 130 $ 165
5. Use of Outside Laboratory $ 375 $ – 90 $ 180 $ 165

In the negotiated transfer pricing the price negotiated will not have any specific relationship with either the cost or the market price (Horngren, Foster, & Datar, 2002). Nevertheless, cost and price information can be taken as the starting point for the negotiation of transfer price in between the hospitals. The chief advantage of transfer pricing is that it maintains the autonomy of the division since the transfer price is arrived based on the direct negotiations between the managers of the hospitals. Another advantage of transfer pricing is that it encourages the hospital managers to strengthen their efforts to increase the profitability of their hospitals by controlling the cost. However, the negotiated transfer pricing has a major disadvantage of the time and energy spent on prolonged negotiations of transfer prices.

References

AccountingforManagement. (2008). Negotiated Transfer Pricing. Web.

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Horngren, C. T., Foster, G., & Datar, S. M. (2002). Cost Accounting: A Managerial Emphasis. New Delhi: Prentice Hall of India Private Limited.

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Paperroni. (2022) 'Academic and Western: Cost Allocation as Transfer Pricing'. 12 March.

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