In organizations with multiple divisions or departments, the question of pricing products from one division to another becomes important (e.g., the price that one division should charge or be allowed to charge another for goods and services).
In this article, the objectives and techniques of transfer pricing are discussed. Examples are also provided to illustrate the concept in actual practice.
Definition: Transfer Pricing
Transfer price is the internal price at which goods and services are transferred from one profit or investment center to another profit center within the same company.
Transfer pricing becomes necessary in order to determine whether organizational objectives are being achieved in each department of a company. They are also important in evaluating divisional performance.
Generally, transfer prices should fulfill three objectives.
First, transfer prices should promote goal congruence and optimal decision-making. The objectives of the various divisions or departments in a company should be consistent with the overall objectives of the company as a whole.
If the divisions take independent actions, they may not be in the best interest of the organization as a whole.
For example, if the buying and selling profit centers in a company maximize their individual performance, transfer pricing problems may be created.
Second, transfer pricing should enable reliable performance appraisals for each independent unit of an organization.
Management must properly evaluate the transfer prices of each division so that it helps them in assessing the true worth of each division, evaluates the contribution made by the division to total company profits, and also helps them in decision-making.
Finally, divisional managers should develop offers of transfer prices that reflect the cost structures of their divisions and also maximum divisional autonomy.
For example, if the division is operating below capacity, a transfer price that falls between incremental cost and market price is usually the best. When the division is operating at full capacity, a market-based transfer price is best.
If divisions are free to buy and sell outside the firm, the use of market prices leads divisions to maximize the goals of the organization also.
The best transfer pricing system is one that helps managers to make decisions that are in the best interests of the firm as a whole.
When managers are free to negotiate transfer prices, they are likely to make decisions that benefit both the division and the firm as a whole.