Transfer Pricing--Market-Based vs. Cost-Based

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Transfer pricing is one of the key factors of a management control system, which helps a company to achieve its goals, including profit maximization and tax minimization. There are several methods of setting transfer prices among profit centers within the same organization. Each profit center tries to set transfer prices which maximize their own profit. The buying and selling profit centers’ profits are largely affected by transfer prices. For example, when a high transfer price is charged, the selling division’s profits increase, while the buying division’s costs increase. So, transfer pricing should be established on a reasonable and objective basis, which should maximize the companywide profit, rather than being based on an individual division’s profit. The company can choose market-based transfer pricing, cost-based transfer pricing, or negotiated transfer pricing. We will mainly focus on comparing market-based transfer pricing and cost-based transfer pricing in order to evaluate which method is more appropriate in each case. We will also analyze an entity’s transfer pricing policy. Market-Based Transfer Pricing

First of all, market-based transfer pricing tries to align the incentives of profit centers with the overall companywide goal. Market-based transfer pricing is ideal, and achieves congruence of the company’s goals, when the market is perfectly competitive. However, it is hard to have a perfectly competitive market. Eccles (1985) argues that market-based transfer pricing is appropriate when diversification is high. This may result from the general manager’s ability to understand cost pools completely and apply them to transfer pricing. For example, in the case of a highly diversified firm, such as General Electronics, the general manager cannot completely understand the cost of each division. In that case, the general manager may set transfer prices based on market prices. Eccles also argues that the general manager should mandate market-based transfer pricing when vertical integration is high, and exchange autonomy when vertical integration is low. In circumstances where a company values its autonomy highly, market-based transfer pricing is effective only when the buying division is willing to pay the market price for the selling division in the same company. The buying division can contribute to incremental profits for the company simply by purchasing the products from the selling division and either reselling them outside the company, or using the products in its own production process. So, the successful adoption of market-based transfer pricing depends on the cooperation of the buying division when the company considers autonomy as one of the key factors for success. Emmanuel and Mehafdi (1994) argue that transfer pricing is determined by several factors, including strategy with respect to differentiation. Companies should choose market-based transfer prices when they choose a low-cost approach to develop a sustainable competitive advantage in the market. This is reasonable, because companies have to focus on reducing costs under a low-cost strategy. However, trying to minimize costs does not make transfer pricing more accurate. It rather tends to increase conflicts between divisions. Each division manager makes an effort to set a transfer price which is profitable for their own division. For example, when companies use cost-based transfer prices, the buying division would like to pay the standard cost for intermediate products, and the selling division would like to sell using the full-cost system. It is better for the companies to use a market-based transfer price to avoid the conflicts between profit centers. The transfer pricing method is also affected by performance evaluation. Borkowski (1992) argues that the use of division profit for performance evaluation contributes to the transfer pricing method. When the company links performance evaluation with division profit, and divisional...
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