International Strategy: WBA 434 Professors Heath, Huddart, & Slotta
Transfer Pricing 1. Overview
An essential feature of decentralized ﬁrms is responsibility centers (e.g., cost-, proﬁt-, revenue-, or investment-centers). The performance of these responsibility centers is evaluated on the basis of various accounting numbers, such as standard cost, divisional proﬁt, or return on investment (as well as on the basis of other non-accounting measures, like market share). One function of the management accounting system therefore is to attach a dollar ﬁgure to transactions between diﬀerent responsibility centers. 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. The basic purpose of transfer pricing is to induce optimal decision making in a decentralized organization (i.e., in most cases, to maximize the proﬁt of the organization as a whole). Proﬁt Center : Any sub-unit of an organization that is assigned both revenues and expenses. In a proﬁt center, a manager is treated as an entrepreneur. Typically, a proﬁt center manager is given decision-making power and is held responsible for the proﬁts generated by her center.
Advantages and Disadvantages of Decentralization
• Decisions are better and more timely because of the manager’s proximity to local conditions. • Top managers are not distracted by routine, local decision problems. • Managers’ motivation increases because they have more control over results. Based on a note by Nahum Melumad.
c Heath, Huddart & Slotta, 2009. All rights reserved.
WBA 434: International Strategy
• Increased decision making provides better training for managers for higher level positions in the future. 2.2 Disadvantages
• Lack of goal congruence among managers in diﬀerent parts of the organization. • Insuﬃcient information available to top management; increased costs of obtaining detailed information. • Lack of coordination among managers in diﬀerent parts of the organization.
Purposes of Transfer Pricing
There are two main reasons for instituting a transfer pricing scheme:
• Generate separate proﬁt ﬁgures for each division and thereby evaluate the performance of each division separately. • Help coordinate production, sales and pricing decisions of the diﬀerent divisions (via an appropriate choice of transfer prices). Transfer prices make managers aware of the value that goods and services have for other segments of the ﬁrm. • Transfer pricing allows the company to generate proﬁt (or cost) ﬁgures for each division separately. • The transfer price will aﬀect not only the reported proﬁt of each center, but will also aﬀect the allocation of an organization’s resources.
Mechanics of Transfer Pricing
• No money need change hands between the two divisions. The transfer price might only be used for internal record keeping. • (Transfer Price × quantity of goods exchanged) is an expense for the purchasing center and a revenue for the selling center. Page 2
International Strategy: WBA 434
Accounting for Transfer Pricing
If intra-company transactions are accounted for at prices in excess of cost, appropriate elimination entries should be made for external reporting purposes. Examples of items to be eliminated for consolidated ﬁnancial statements include: • Intracompany receivables and payables. • Intracompany sales and costs of goods sold. • Intracompany proﬁts in inventories.
Alternative Methods of Transfer Pricing
A transfer pricing policy deﬁnes rules for calculating the transfer price. In addition, a transfer price policy has to specify sourcing rules (i.e., either mandate internal transactions or allow divisions discretion in choosing whether to buy/sell externally). The most common...