TRANSFER PRICING

TRANSFER PRICING Overview The essential feature of decentralization in large firms is the creation of responsibility centers (e.g. cost, profit, or investment centers). The performance of these responsibility centers is evaluated on the basis of various accounting numbers, such as standard and actual cost, divisional profit or return on investment. A central role of the management accounting system therefore is to evaluate (i.e. attach a dollar figure to) the transactions between the different responsibility centers. Under the subject cost allocation we studied alternative methods to charge user departments for the services rendered by service departments (frequently cost centers). Transfer prices are used to evaluate the goods and services exchanged between profit centers (divisions) of a decentralized firm. Hence, 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. # There are no cash flows between the divisions. The transfer price is used only for accounting purposes. # The transfer price becomes an expense for the receiving manager and a revenue for the supplying manager. # If intra-company transfers are accounted for at prices in excess of cost, appropriate elimination entries have to be made for external reporting purposes. Examples of items to be eliminated for consolidated financial statements include: # Intra-company receivables and payables. # Intra-company sales and costs of goods sold # Intra-company profits in inventories. Purposes of Transfer Pricing There are two major reasons to operate a transfer pricing system: # Appropriate transfer prices help to coordinate the production, sales and pricing decisions of the different divisions. Transfer prices make managers aware of the value that the goods and services have to other segments of the firm. # The use of transfer prices allows the company to generate separate profit figures for each divisions and thereby to evaluate the performance of each division separately. Alternative Methods of Transfer Pricing Transfer pricing policies specify the rules that are being used to calculate the TP. In addition, a TP policy has to be specific about the sourcing question, i.e., are divisions free to buy/sell externally or is it the case that internal transfers are mandated. 1. Market based Transfer Pricing In the presence of competitive and stable external markets, many firms take the external market price as a benchmark for their internal transfer price. Generally, the external market price provides a ceiling not to be exceeded by the internal transfer price. Question: How would you argue that market price is the "correct" TP if the external market is perfectly competitive? Issues with market based TP: • Imperfect Competition • Distress Prices -Protecting "infant" segments 2. 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, H.Q. reserves the right to interfere in the negotiation process and impose an "arbitrated" solution. Question: What do you perceive to be the major advantages/disadvantages of negotiated transfer pricing? 3. Cost based Transfer Pricing In the absence of an established market price many companies base the TP on the production cost of the supplying division. 1. Full (absorption) cost; either standard or actual. Popular because of its simplicity and clarity. 2. Cost plus For transfers at full cost the buying division takes all the gains from trade while the supplying division receives none. To overcome this problem the supplying division is frequently allowed to add a mark up in order to make a "reasonable" profit. The transfer price may then be viewed as an approximate market price.