Market-based Transfer Pricing

Where external markets do exist for the selling centre's products, it is preferable to use market prices rather than cost-based prices. This is because market price is a better guide to the value added to products than a cost-based price which incorporates a profit element. If the external market is competitive and divisional inter-dependence is minimal, the market price generally leads to optimal decisions within the organization, that is, decisions which satisfy the three criteria stipulated above. Where market prices can be used with a large measure of success, the divisions are effectively .separate business entities.

When using market prices, it is essential that the transfer price should be no higher than the buying centre would have to pay on the market. Otherwise, it is evident that an imbalance will be created between the interests of the selling and the buying centres. The existence of an independent market price imposes an upper limit to the transfer price, for given that the selling centre is able to sell at that price, the buying centre should be compelled to buy internally rather than to purchase from external suppliers.

A number of problems arise from the use of the market price as the basis for the transfer price. Thus, changes in supply may lead to large price changes, and the recognition of these changes will cause large variations in the transfer price. As a result, a degree of instability will be introduced in the control mechanism. Further problems are associated with the weight which should be attached to different market price rulings during the transfer period, and to such other factors affecting market prices, such as quantity discounts, area and trade channel differentials, transportation and delivery allowances and service factors. The market price also reflects the result of a bargain, and reconciliation between what one has to accept to effect a sale, and what one has to pay to effect a purchase. The effects of relative bargaining positions on the market price have implications for the transfer price selected-should it favour the selling or the buying division?

Hence the determination of a fair market price for establishing a viable transfer pricing system which will satisfy the three criteria which have been stipulated, calls for a solution to the various problems mentioned above. In many cases, the solution may be arrived at only by an independent arbitrator. This process immediately undermines the third criterion-the preservation of the autonomy of individual divisions-and results in the establishment of a negotiated price.

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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... see: Transfer Pricing