A transfer price is the price one segment (sub-unit, department, division, etc.

) of an organisation charges for a product or service supplied to another segment of the same organisation.

Transfer pricing is the process of determining the price at which goods are transferred from one profit centre to another profit centre within the same company.

A transfer price is an internal charge established for the exchange of goods or services between organizational units of the same company. The transfer from one segment to another is only an internal transfer and not a sale.

Need for transfer pricing

When there are internal transfers of goods or services and it is required to appraise the separate performances of the divisions or departments involved. If profit centres are to be used, transfer prices become necessary in order to determine the separate performances of both the buying and selling profit centres. Transfer prices form part of the information which should: i. Guide decision making ii. Appraise managerial performance iii. Evaluate the contribution made by the division to overall company profits. iv. Assess the worth of the division as an economic unit

Objectives which transfer prices should fulfill

Goal Congruence: The prices should be set so that the objectives of the divisional manager (such as maximisation of divisional earnings) are consistent with the objectives of the company as a whole and so that sub-optimal decision making is not encouraged. Performance Appraisal: The transfer prices should enable reliable assessments to be made of divisional performance. Divisional autonomy: The prices should seek to maintain the maximum divisional autonomy so that the benefits of decentralisation are maintained. The profits of one division should not be dependant on the actions of other divisions

General Rule for Transfer Pricing

Transfer Price = outlay cost(variable costs or incremental costs) + opportunity cost Outlay cost is the additional amount the selling segment must pay to produce and transfer a product or service to another segment. It is often the variable cost for producing the item transferred. Opportunity cost is the maximum contribution to profit that the selling segment forgoes by transferring the item internally.

Fundamental principles for transfer price

The maximum price should be no greater than the lowest market price at which the buying segment can acquire the goods or services externally. The minimum price should be no less than the sum of the selling segments incremental production costs plus the opportunity cost of the facilities used.

Methods of transfer pricing

Cost Based Pricing Market Based Pricing Negotiated Pricing Opportunity Cost Transfer Pricing

Used because the conditions for setting ideal market prices frequently do not exist. Cost-based prices are readily available, but if a company uses actual costs, the receiving segment manager does not know the cost in advance, which makes cost planning difficult. Transfer price may be based on: 1. Variable cost: transfer is made at the variable costs up to the point of transfer. This system is appropriate when the selling division forgoes no opportunities when it transfers the item internally ie. there is excess capacity. Problem: Results in a loss for the selling division so performance appraisal becomes meaningless and motivation will be reduced.

2. Full cost or full cost plus profit Includes variable cost and an allocation of fixed costs. Some companies also add a markup for profit. i. May result in sub-optimal decision particularly when there is idle capacity within the firm. ii. The full cost is likely to be treated by the buying division as an input variable cost so that external selling price decisions, if based on cost may not be set at levels which are optimal for the firm as a whole. iii. Costs may be unacceptably high as far as buying division is concerned if the selling division is inefficient. iv. Genuine performance appraisal is difficult as the selling division is automatically given a certain level of profit in cost plus markup.

 Actual cost Inefficiencies in production may not be corrected- cost inefficiencies are passed along to the buying division. Therefore the supplying division lacks incentive to control its costs. Cost planning is difficult:Buying division will not know its actual cost in advance, it will not be able to accurately plan its costs. Cost based prices undermine divisional autonomy and sometimes may not lead to goal congruence eg. the supplying division may not find it profitable to transfer internally although the transfer may be best for the company as a whole. Standard cost Prevents passing along efficiencies of supplying division to the buying division Standard cost are known in advance thus buying divjision can plan its costs accurately. Buyer could pay more than actual cost for goods

 Used where a market exists outside the firm for the intermediate product and where the market is competitive. Transfer price may be set somewhat lower than market price to reflect the cost savings from internal transfers in case of significant external buying and selling costs.

 Leads to goal congruence if there is a competitive market for the product or service being transferred internally. Market price = variable cost + opportunity cost

Transfer price =variable cost + opportunity cost Transfer price =variable cost + (market price variable cost) Transfer price =market price
Market price may be published list price for similar products or services or price supplying division charges its external customers (internal transfer price= external market price less the selling and delivery expenses not incurred on internal business)

 Advantages Both seller and buyer should accept Usually leads to goal congruence and optimal decisions Realistic Performance evaluation is possible Divisional autonomy is maintained selling division can sell in the open market or internally and the buying division has the option of purchasing in the market place or internally Problems Market price are not always available for internally transferred items Product may not be sold in open market Internal cost savings may exist External market may temporarily be high or low Determination of right market price may be difficult

Set by negotiation between selling and buying divisions based on factors such as:
Costs involved, alternative outside sales opportunities, (market prices) the impact of added volume on the operating capacity of the transferor division purchase options to the buyer and effect of the transaction on the total profit of the firm,etc.

Normally below external sales price Above units incremental costs, (will include opportunity cost) In case agreement is not reached arbitration by central management may be required. Managers must have authority to go outside the company if negotiations fail

Benefits
Optimal decisions: May lead to decisions which are in the interest of the firm as a whole . Managers involved have the best knowledge of what the company will gain or lose by producing and transferring the product or service Acceptable to the concerned parties. Maintains divisional autonomy

Problems :
1. Time consuming and may divert managerial energies away from their primary tasks. 2. Unequal bargaining power of parties concerned. 3. Disagreements may arise and this may require arbitration by central management which itself undermines divisional autonomy and may cause resentment. The objective of divisionalisation is to enhance overall efficiency and inter-divisional wrangling over transfer prices should not nullify any benefits.

The central management sets the transfer price at a level which equals the opportunity cost of the supplying division and the buying division. If the buying division fails to provide adequate orders for the supplying division the amount of contribution in respect of the production foregone due to lack of orders should be charged from such division. Both divisions are encouraged to produce and consume that quantity which is optimal from the point of view of the company as a whole. Suitable in case of i. non-existence of market for intermediate products or ii. when supplying division is a monopoly producer or iii. the buying division is a monopoly consumer.