CHAPTER 6

TRANSFER PRICING

Todays organizational thingking is oriented toward decentralization. One of the principal

challenges in operating a decentralized system is to devise a satisfactory method of
accounting for the transfer of goods and services from one profit center to another companies
that have a significant number of these transastions.
Objectives of Transfer Prices
The transfer price is the mechanism for distributing this revenue. The transfer price should be
designed so that it accomplishes the following objectives :

Provide information on costs & revenues

Promote goal congruence
Help measure unit economic performance
Simple and easy to implement

Transfer Pricing Methods

The fundamental principle is that the transfer price should be similar to the price that
would be charged if the product were sold to outside customers or purchased from outside
vendors.
When profit centers of a company buy products from, and sell to, one another, two
decisions must be made periodically for each product :
1. Should the company produce the product inside the company or purchase it from an
outside vendor? This is the sourcing decision.
2. If produced inside, at what price should the product be transferred between profit centers?
This is the transfer price decision.
Ideal Situation for Transfer Price Systems

Competent people
Good atmosphere
A market price
Freedom to source
Full Information
Negotiation

Constraints on Sourcing
Ideally, the buying manager should be free to make decisions. Similarly, the selling
manager should be free to sell products in the most advantageous market. In real life,

however, freedom to source might not be feasible or, if it is feasible, might be constrained by
corporate policy.
Limited markets
If does not buy or sell the product in an outside market, so the competitive price: published
market prices, bids, production profit center, buying profit center, excess or shortage
industry capacity.
Cost-Based Transfer Prices
If competitive prices are not available, transfer prices may be set on the basis of cost plus
a profit, even though such transfer prices may be complex to calculate and the results less
satisfactory than a market-based price. Two decisions must be made:
(1) The Cost Basis: Standard cost (not actual cost)
(2) The Profit Markup
Percentage of cost
Percentage of investment (pose a practical problem)
Pricing Corporate Services

Control over amount of servive

Standard variable cost of descretionary services

Optional use of services (ekternal)

Information technology
Internal consulting group
Maintenance work

Simplicity of the Price Mechanism

Reduce counterproductive

Administration of Transfer Price

Negotiation

 Arbitration and conflict resolution

Product classification
Large volume (senior management wish to control)
Small volume (no significant disruption)

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