Transfer pricing

Introduction

Transfer pricing deals with the problem of pricing products or services sold (Transferred within an organisation). Decisions over the appropriate transfer price have to be considered, typically if the business is decentralised or is involve in prices between connected companies in different countries. The approach to setting transfer prices is similar to those for external sales, there are cost-based methods and market based methods.

At first sight it would seem that setting prices for internal transfers is less critical than for external sales; however it has to be appreciated that the divisions into which a large group will split itself expect to act as self-contained units. The decision over transfer pricing is even more critical since top management is in a position to identify whether it is more economical for a product or service to be bought and sold internally or externally, but at the same time needs to take into account behavioural considerations such as the motivation of divisional managers.

It might appear that the credit to the supplying division is merely offset by an equal debit to the receiving division and that therefore, as far as the whole organisation is concerned, it has a net zero effect. This is true in terms of the physical application of a transfer pricing system once it has been decided upon and implemented.

However, there are important behavioural and organisational elements associated with transfer pricing and the choice of which method to adopt. The transfer price does affect the profit of each division separately and, therefore, can affect the level of motivation of each divisional manager.

Transfer pricing policy 

Adopting a transfer pricing policy will result in:

  • Total corporate profit to be divided up between divisional profit centre’s, it may result in a cost centres being converted into a profit centres.
  • Information becoming available for divisional decision-making.
  • Information being made available to help assess the performance of divisions and divisional managers.

The rules for the operation of a transfer pricing policy are the same for any policy in a decentralised organisation. A system should be reasonably easy to operate and understand as well as being flexible in terms of a changing organisational structure.

In addition, there are four specific criteria which a good transfer pricing policy should meet:

  • It should provide motivation for divisional managers.
  • It should allow divisional autonomy and independence to be maintained.
  • It should allow divisional performance to be assessed objectively.
  • It should ensure that divisional managers make decisions that are in the best interests of the divisions and also of the company as a whole. (Goal congruence).

Setting the transfer price

In the majority of cases the transfer price will be set somewhere between these two extremes. It is important that the criteria used to pick a price are easy to understand and that the impact of the price on the profits of the two segments can be easily evaluated.

The difference between the upper and lower prices represents the corporate profit/savings generated by producing the product or service internally. The chosen price “divides” the profit between the two segments. For external reporting this is irrelevant since the profit element will be eliminated when the financial statements are consolidated.

However this division of profits may be extremely important for internal reporting since it affects the results of the responsibility reports and hence the success or failure of the segment.

There are three main methods used to set the transfer price:

Cost-Based Transfer Prices

The big problem with cost-based prices is deciding on the cost to be used. Is it to be an actual or standard cost? Will it be fully absorbed cost or variable cost and if so what will be included? Will there be additional elements to cover general and administrative costs for example?

If actual costs are used then the cost may vary according to the season or according to the efficiency of the supplying segment and the receiving segment will have no idea how to set its sales prices. What additional costs are included and are they reasonable or have they been inflated?

Market-Based Cost

Market pricing is believed to be an objective arm’s length method of arriving at a transfer price. If a supplying segment is operating efficiently it should be able to make a profit at this price. Similarly if the receiving segment is operating efficiently it should be able to make a profit since it would have to purchase at this price if the item was not manufactured internally.

However several problems may exist in practice. First market price may not be appropriate because internal production should lead to savings in bad debt, delivery and marketing expenses. The product or service may not be available on the open market. If the market price is temporarily depressed or increased due to events beyond the control of either segment which price should be taken, the normal or the temporary? Finally, in a market, discounts on price are ordinarily given when volume orders are placed or long-term contracts are signed. Finally the market price may not equal the LRMC and in this case the company will fail to set it price/output decisions correctly, although this is less true of commodity products.

Negotiated Transfer Prices

Some companies allow business segments to negotiate the transfer price, usually between the upper and lower limits set out above. There is an implication here that the buying segment has the right to purchase form external sources if it cannot agree a price.  Such freedom runs the risk of sub optimisation as segment managers’ fight to gain the lion’s share of the available profit. For this reason the company may specify arbitration processes and for performance management purposes may evaluate managers on the basis of the total profit made by both segments, irrespective of the segment n which they work.

Dual Pricing

To overcome these problems companies can adopt the practice of dual pricing. Here the agreed transfer price is used only for the purposes of financial reporting of individual segment results. For management evaluation purposes the variable or absorbed cost is applied to the results of one or both segments. The difference between the “entity” and management price is called the “mark-up”.

The mark-up is accounted for by assigning it to a different account that is used for reconciliation purposes. That is to say the amount of mark-up in the buying segment’s accounts must equal the amount of mark-up in the selling segment’s accounts. This reconciliation is the same as is done for the purposes of consolidation of the accounts.

Using dual pricing allows a company to get the best of both worlds. The transfer price can be set to meet the regulatory and corporate finance constraints while the price used by local management can be based on a close approach to the economist’s long-run marginal costs so allowing the company’s global operations to optimize their third-party pricing and output decisions on a decentralized management basis.