Transfer Price:
Internal price for the exchange of goods or services between organizational units of a company

One part of the company provides a good or service to another part of the company and charges a “transfer price” for it

One part of the company records revenue
One part of the company records costs of goods sold/service

Used for internal reporting purposes only in companies that have more than one segment or division

Often used by cost centers to become a profit center

An appropriate transfer price should ensure optimal resource allocation and promote operational efficiency.

 

General Rules for Determining the Transfer Price:

1) Maximum:
No higher than the lowest price it can be purchased outside the company

 

2) Minimum:
The total of incremental costs: all variable costs plus any added fixed costs

 

If at capacity:
Add lost contribution margin from other customers that will not be served.
The total will be the sales price to outside customers

3) Negotiated:
Between the minimum and maximum is usually acceptable
Management decides an acceptable price

 

Common Methods for Determining the Transfer Price:

1) Cost Based:
Different methods include different costs

Total absorption cost (full cost):
Includes all variable production costs + allocated manufacturing overhead

Incremental cost:
Includes all variable costs that will increase and all added fixed costs

 

2) Market Based:
Use the selling price that would exist if the segments were independent companies.

Considered to be the most objective

 

3) Negotiated:
Managers of the two segments negotiate a price

 

Dual Pricing Arrangement:
The selling division records the transfer at market price and the buying division records the purchase based on cost.

The difference is recorded to an inter-company profit/transfer account.

The final pricing arrangement should always reflect organization goals.
This will vary among companies and business circumstances.

 

Advantages of a well thought out transfer price:

1) allows for fair evaluation of segment performance

2) allows for rational use of goods among segments/divisions

3) motivates managers to achieve goal congruence in decentralized organizations

 

International Transfer Pricing:

1) The impact of different tax rates for segments in different countries is considered an important factor in determining the transfer price.

The segment with the lowest tax rate should earn higher profits

 

A good transfer pricing system will:

1) appropriately utilize company resources

2) minimizes goal conflicts among divisions/segments

3) balances short and long-term goals of the entire company