Question

Transfer pricing involves setting a price on goods that are transferred between divisions within a single company. Is this practice necessary? What are the advantages? Disadvantages? What’s an appropriate price if it’s going to be done?

Answer 1

Transfer price:-
Transfer price is the price at which divisions of a company transact with each other, such as the trade of supplies or labor between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. A transfer price can also be known as a transfer cost.

Purposes of Transfer Pricing:-

*The transfer pricing method allows the company to generate profit figures for each division in separate manner.
*The sales, pricing and the production departments can be coordinated through this method. The managers can also get aware of the value of the services and the products in other segments of the firm.
*It helps in generating not only the reported profits of the entire center but also the resource allocation of the organization.
*Performance evaluation of each department becomes easy as it can generate separate profits.
*There can be disagreement among organisational divisional managers as to how the transfer price should be set.

Advantages:-

*it allows for coordination
*it allows for performance evaluation
*it helps focus the minds of top management of other aspects of the company
*It encourages and motivates the managers because they have a sense of independence
*It helps prepare managers for future higher level positions

Disadvantages:-

*Additional costs, time and manpower will be required to execute transfer prices and design the accounting system.
*For some departments or divisions, for example service departments, transfer prices do not work equally well because these departments do not provide measurable benefits.
*Transfer prices may cause dysfunctional behaviour among managers of organisational units.
*The issue of transfer prices in multinational companies is highly complicated.

Here are a number of ways to derive a transfer price:

*Market rate transfer price. The simplest and most elegant transfer price is to use the market price. By doing so, the upstream subsidiary can sell either internally or externally and earn the same profit with either option. It can also earn the highest possible profit, rather than being subject to the odd profit vagaries that can occur under mandated pricing schemes.
*Adjusted market rate transfer price. If it is not possible to use the market pricing technique just noted, then consider using the general concept, but incorporating some adjustments to the price. For example, you can reduce the market price to account for the presumed absence of bad debts, since corporate management will likely intervene and force a payment if there is a risk of non-payment.
*Negotiated transfer pricing. It may be necessary to negotiate a transfer price between subsidiaries, without using any market price as a baseline. This situation arises when there is no discernible market price because the market is very small or the goods are highly customized. This results in prices that are based on the relative negotiating skills of the parties.
*Contribution margin transfer pricing. If there is no market price at all from which to derive a transfer price, then an alternative is to create a price based on a component’s contribution margin.
*Cost-plus transfer pricing. If there is no market price at all on which to base a transfer price, you could consider using a system that creates a transfer price based on the cost of the components being transferred. The best way to do this is to add a margin onto the cost, where you compile the standard cost of a component, add a standard profit margin, and use the result as the transfer price.
*Cost-based transfer pricing. You can have each subsidiary transfer its products to other subsidiaries at cost, after which successive subsidiaries add their costs to the product. This means that the final subsidiary that sells the completed goods to a third party will recognize the entire profit associated with the product.