More notes about domestic TP
There are no cash flows associated with transfer pricing. In a decentralized firm, transfer prices generally play two important roles: 1. Allocate profits between different tax jurisdictions for taxation purposes 2. Coordinate economic activity within the firm
Firms can choose to use different transfer prices for taxes and financial/internal reporting. The use of transfer prices allows central management to generate individual profit figures for different divisions.
The transfer price is an expense on the income statement of the receiving division, and a revenue on the income statement of the supplying division.
Transfer Pricing and Economic Coordination:
In a decentralized firm, transfer prices determine the divisions’ willingness to trade and the quantity they trade. A well-designed transfer pricing policy will motivate the divisions to behave in a way that maximizes overall firm profit.
Rule of Thumb: Transfer Price for Optimal Trade Quantity
Transfer Price=Outlay Cost + Opportunity Cost
The transfer price should reflect the seller’s marginal cost of transferring a good internally. This is also the firm’s marginal cost. Specifically, this rule implies:
1. If the selling division has no external market:
Transfer Price = Marginal Production Cost
Are we holding the selling division to zero profit? More about this later....
2. If the selling division faces a competitive external market: Transfer Price = Market Price minus any cost savings for internal transfers What if the firm is not operating at capacity?
3. If the selling division faces an uncompetitive external market: Transfer Price = ?
What is the marginal cost of an internal transfer if the selling division is a monopolist that is not operating at capacity?
When do transfer prices matter most?
We noted above that when there is no external market for the intermediate good, the optimal transfer price is marginal production cost, which can...
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