An essential feature of decentralized firms is responsibility centres (e.g., cost, profit, revenue, or investment centres). The performance of these responsibility centres is evaluated on the basis of various accounting numbers, such as standard cost, divisional profit, or return on investment (as well as on the basis of other non-accounting measures, like market share). One function of the management accounting system therefore is to attach a dollar figure to transactions between different responsibility centres. The transfer price is the price that one division of a company charges another division of the same company for a product transferred between the two divisions. The basic purpose of transfer pricing is to induce optimal decision making in a decentralized organization (i.e., in most cases, to maximize the profit of the organization as a whole).
Purposes of Transfer Pricing
The main reasons for instituting a transfer pricing scheme are as follows:
• Generate separate profit figures for each division and thereby evaluate the performance of each division separately.
• Help coordinate production, sales and pricing decisions of the different divisions (via an appropriate choice of transfer prices). Transfer prices make managers aware of the value that goods and services have for other segments of the farm.
• Transfer pricing allows the company to generate profit (or cost) figures for each division separately.
• The transfer price will affect not only the reported profit of each centre, but will also affect the allocation of an organization’s resources.
Mechanics of Transfer Pricing
• No money need change hands between the two divisions. The transfer price might only be used for internal record keeping.
• (Transfer Price × quantity of goods exchanged) is an expense for the purchasing centre and revenue for the selling centre.
Accounting for Transfer Pricing
If intra-company transactions are accounted for at prices in excess of cost, appropriate elimination entries should be made for external reporting purposes. Examples of items to be eliminated for consolidated financial statements include:
• Intracompany receivables and payables.
• Intracompany sales and costs of goods sold.
• Intracompany profits in inventories.
Market-based Transfer Pricing
When the outside market for the good is well-defined, competitive, and stable, firms often use the market price as an upper bound for the transfer price.
Negotiated Transfer Pricing
Here, the firm does not specify rules for the determination of transfer prices. Divisional managers are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer pricing is typically combined with free sourcing. In some companies, though, headquarters reserves the right to mediate the negotiation process and impose an “arbitrated” solution.
Cost-based Transfer Pricing
In the absence of an established market price many companies base the transfer price on the production cost of the supplying division.
The most common methods are:
• Full Cost
• Variable Cost plus Lump Sum charge
• Variable Cost plus Opportunity cost
• Dual Transfer Prices