Transfer Pricing

From the foregoing, the use of profit centres for the control of divisional performance may give rise to the problem of determining the price at which the product of one profit centre should be transferred to another profit centre. The transfer price is critically important to the profit of both centres, being at once revenue to the selling centre and cost to the buying centre. The evaluation of managerial performance based on the size of the divisional profit requires that the transfer price should be so calculated as to reflect accurately the value-added to the product by the selling centre. If it is set too high, it will reflect too favourably upon the selling centre and too unfavourably upon the buying centre, and vice-versa. Hence, financial results may be heavily biased by the prices adopted for the transfer of intermediate goods. Defects in the transfer price mechanism may frequently invalidate the conclusions which divisional profit figures might seem to suggest. In such cases, these figures may not merely fail to produce the right decisions, they may actively promote wrong ones.

We have examined pricing as a means of regulating the exchange of the firm's products with the outside world. Here, we shall examine transfer pricing as a method of controlling the activities of profit centres within the firm. Hence, we shall see that the distinction between pricing and transfer pricing lies in their different purposes.

Transfer prices should satisfy the following three criteria:

(a) They should promote goal congruence within the organization by harmonizing the interest of individual divisions with the interest of the organization as a whole, by preventing divisional managers from optimizing divisional profits by policies which are harmful to the rest of the organization.

(b) They should make possible reliable assessments of divisional performance for the following purposes:

(i) making predictions for decision-making purposes

(ii) appraising managerial performance

(iii) evaluating the divisional contribution to corporate profits.

(c) They should ensure that the autonomy of the individual divisions is respected, and that their profits are not dependent upon the actions of other divisions.

Transfer pricing methods

There are three main methods for establishing transfer prices:

(a) market-based transfer pricing

(b) cost-based transfer pricing

(c) negotiated pricing.

Learn More About Cost-volume-profit Analysis

Read on: Profit Centres

In recent years, there has been a tendency for organizations to grow in size, and the problem of control which this growth has created has encouraged the devolution of Publisherity in large organizations by the creation of organizational structures based upon the concept of 'divisions'. The rationale underlying this process of decentralization is founded on the belief that divisionalization enhances overall corporate profitability. Several reasons are adduced for this belief. Firstly, the responsibility for decision making is transferred to executives who are 'on the spot', and who are directly concerned... see: Profit Centres