Transfer pricing is a popular topic in management accounting. It is concerned with the price when one department (the selling department) provides goods or services to another department (the buying department). That is, one department generates revenue from the sales of goods or services and the other department incurs expenses from the purchases of goods or services. Transfer pricing is closely related to responsibility accounting in which each department is responsible for its cost, revenue, expense or investment return depending on the type of centre it is. Thus, transfer pricing effectiveness is essential to the success of the overall company. The related key issue is the determination of a transfer price which brings goal congruence to the company, and to the buying and the selling departments, as all parties want to make a profit.
Transferred product can be classified along two criteria. The first criterion is whether there is a readily-available external market price for the product. The second criterion is whether the buying division will sell the product “as is,” or whether the transferred product becomes an input in the buying division’s own production process. When the transferred product becomes an input in the production process, it is referred to as an intermediate product.
Transfer pricing serves the following purposes:
1. When product is transferred between profit centers or investment centers within a decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect divisional performance evaluation.
2. When divisional managers have the authority to decide whether to buy or sell internally or on the external market, the transfer price can determine whether managers’ incentives align with the incentives of the overall company and its owners. The objective is to achieve goal congruence, in which divisional managers will want to transfer product when doing so maximizes consolidated corporate profits, and at least one manager will refuse the transfer when transferring product is not the profit-maximizing strategy for the company.
3. When multinational firms transfer product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues.
The transfer generates journal entries on the books of both divisions, but usually no money changes hands. The transfer price becomes an expense for the buying division and revenue for the selling division. TYPES OF TRANSFER PRICES AND THEIR DETERMINATION
There are three general methods for establishing transfer prices.
1. Market-based transfer price: In the presence of competitive and stable external markets for the transferred product, many firms use the external market price as the transfer price.
2. Cost-based transfer price: The transfer price is based on the production cost of the selling division. A cost-based transfer price requires that the following criteria be specified: a. Actual cost or budgeted (standard) cost.
b. Full cost or variable cost.
c. The amount of markup, if any, to allow the selling division to earn a profit on the transferred product.
3. Negotiated transfer price: Senior management does not specify the transfer price. Rather, divisional managers negotiate a mutually-agreeable price.
Market-based Transfer Prices:
Microeconomic theory shows that when divisional managers strive to maximize divisional profits, a market-based transfer price aligns their incentives with owners’ incentives of maximizing overall corporate profits. The transfer will occur when it is in the best interests of shareholders, and the transfer will be refused by at least one divisional manager when shareholders would prefer for the transfer not to occur. The selling division is generally indifferent...