Transfer price is an important factor in evaluating divisional performance measurement. This is mainly because of the desire of the selling and buying divisions of the same company to maximize their individual performance.
A great deal of intra-firm buying and selling occurs in decentralized firms, which necessitates the setting of transfer prices.
For example, a textile mill might sell some of its cloth to outsiders and some of its cloth for further processing to divisions within the same firm. In this case, transfer prices must be set.
Transfer Pricing Policies
In actual practice, the transfer price of goods and services is usually subject to much controversy. The pricing method to be used also depends upon many factors. Some of the important transfer pricing policies are:
1. Market Price
When there is an existing market outside the firm for the intermediate product and the market is competitive, then the use of market price as the transfer price between divisions is ideal.
It leads a company’s divisions to act in a way that maximizes corporate goal congruence. However, there are difficulties when implementing this policy.
First, outside market prices may not be available for the product or service being considered.
Second, when the prices are available and the market does exist, it may not be truly representative. For example, the market price may be controlled by one or two large companies or the market may not be perfectly competitive.
Also, market prices may not be the right choice as a transfer price if there is considerable excess capacity in the market or the selling division is operating below capacity.
Third, all product transfers do not necessarily have equivalent external markets. For example, a price is only strictly comparable when all features are identical.
Notwithstanding the above, market-based transfer prices are generally the best and are usually used to make reliable assessments of divisional performance.
2. Full Cost With or Without a Profit Markup
Under this system, transfer prices are based on full costs with a percentage mark up on total costs in some other cases. Such a price system is commonly used because there may be no intermediate market that helps to set a transfer price.
This method gives no incentive to the selling division to keep its costs down. The selling manager is automatically given a certain level of profit with the percentage markup at full cost.
Also, the selling manager makes more profit by allowing costs to increase, and the cost that is calculated is only accurate at one level of output. Hence, this method suffers from the drawback that sub-optimal decision-making may occur within the firm.
3. Variable Cost
This method is theoretically the best choice when the selling division has excess capacity. The manager will establish a transfer price equal to variable costs. This helps the manager to make decisions that are optimal from the organization’s viewpoint.
However, variable cost-based transfer policies cause the supplying division to report zero profits or a loss equal to fixed cost.
Performance evaluation of the division also becomes difficult and meaningless in this case. One possible way of partially resolving this problem is to credit the supplying division with a share of the overall profit arising due to the transferred item.
4. Negotiated Transfer Pricing
This pricing scheme allows the supplying and buying division to negotiate with each other and then set the transfer price. It tries to preserve divisional autonomy and is assumed to lead to optimal decisions in the best interests of the firm as a whole.
However, if the buying and selling divisions do not independently agree on a price or the parties concerned do not have equal bargaining power, then negotiated transfer prices may lead to suboptimal decisions.
The existence of an arbitrator to settle disputes also reduces the autonomy of a company’s divisions. Hence, negotiated transfer prices are best when both divisions have equal bargaining power.
In summary, firms should set transfer prices at levels that reflect the cost structures of their divisions and available alternatives. Ideally, transfer prices should be set in a manner that meets all the criteria for inducing top management’s desired decisions.
Such prices should encourage managers to take actions that benefit the firm as a whole. No single transfer price is best—the best transfer price depends on the circumstances at hand.