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Transfer prices are prices charged internally, between different parts of the same organization, for services or products. A study of transfer pricing involves gaining an understanding of the costs involved within an organization and the motivational outcomes of the prices that are set. This brief guide looks at the main issues that must be taken into account when setting transfer prices.
What do we Mean by Transfer Pricing?
Transfer prices are the prices charged internally, between different parts of the same organization, for products or services. This article looks at the main issues involved in setting transfer prices.
The Ideal Approach
Transfer prices should be set appropriately so as to motivate and guide financial decision-making.
The ideal transfer price is the market or ‘external’ price. The department that is buying the resource would not pay more per unit from an internal supplier than the standard market price or else they would go to an alternative external supplier. The department that is selling the resource, would not accept less from the purchasing department than from an external customer, otherwise they would not be making the maximum profit possible per unit of resource.
The amendment to this rule is when both departments are under the same management, and for some reason it is in the organization’s best interest to subsidize the product or service, which is being transferred. In this case, the transfer price is less than the market price.
A Quick Example
In an organization where marketing/shipping/delivery/ packaging costs are added to make the total external price, these are generally subtracted from the market price to arrive at the transfer price, for example:
An organization that produces both soft drinks and cans. The can-making division sells the drinks cans externally at a cost of 10c per can. The cans cost 8c to make plus 1c marketing and shipping, leaving 1c profit per can. The manager of the drinks department wishes to buy the cans from the can department, who subsequently charges him 9c per can. The can department is still making the maximum profit possible per can, whereas the drinks department is actually incurring a lesser cost than they would if they bought the cans externally at a market price of 10c.
A Bit More About the Rules
The above rules are not always applicable to transfer pricing –for one thing, an external market for a component or service may not always exist. In such a case, transfer pricing is approached in an alternative manner. It could be that the transfer price in this situation would be the sum of the actual cost of producing the product, plus a notional added profit.
Costs can also be used as a guide for transfer pricing and in this case, the transfer price would be the total costs incurred just to produce the extra stock and to transfer it to the other department. This approach would be appropriate if there was insufficient external demand for a product, which was still being produced at its original rate. If external demand equals the rate of production, then the product would be sold externally at its market price, to make maximum profit.
The above rules for transfer pricing can unfortunately sometimes result in dysfunctional behavior, which goes against the ultimate goals of the organization. This is due to the fact that department level goals are not pulling in the same direction as the organizational goals.
This can be avoided only if the team members are motivated by sufficient reward for themselves and their department as a result of making transfer pricing decisions that will benefit the organization as a whole.
Varying the transfer prices can cause people to be motivated in different directions. Many circumstantial factors are taken into consideration when fixing transfer prices. Transfer prices can often vary according to taxes and tariffs to ensure that the parent organization benefits, even at the expense of a single department.
