In: Accounting
When divisions transfer products or render services to each other, a transfer price is used to charge for the products or services. Explain the three approaches to setting transfer prices and provide an example of each.
Transfer Pricing comes into play when departments of the same entity transfer products or render services to one another.
Approaches to setting transfer are:
1.Negotiated Transfer Pricing: When departments(or subsidiaries) supply goods or services to each other, they may negotiate the prices with each other as they do with outside suppliers. This method is typically used when market prices for goods or services supplied is not available or market is too small or products are highly customized. Fair price here depends upon excess capacity with supplying department. Minimum and maximum prices are set by both departments.
E.g : Used when departments are under separate management.
2. Cost-based Transfer Pricing: Under this method, each department supplies goods or services at cost to another department, and the final department records the Profit when supply is made to Outside Customer. Cost is based on variable cost only.
E.g : Used when overall profits are to be calculated for entity wide operation.
3. Market rate based Trnasfer Pricing: Under this, transfer price is based on Market price of goods or services such that each department recognises its own profit or loss. When consolidated financials are prepared, the same require adjustment, however, Individual Department performances can be easily measured.
E.g: Used when departmental performances are to be measured.