Transfer Pricing
- 1. THE AMOUNT CHARGED WHEN ONE DIVISION SELLS GOODS OR SERVICES TO ANOTHER DIVISION IS CALLED TRANSFER PRICE. THE TRANSFER PRICE ASSUMES IMPORTANCE IN THE CONTEXT OF MEASUREMENT OF PERFORMANCE IN THE PROFIT CENTRES OR INVESTMENT CENTRES.
- 2. THE GOAL IN SETTING TRANSFER PRICES IS TO ESTABLISH INCENTIVES FOR AUTONOMOUS DIVISION MANAGERS TO MAKE DECISIONS THAT SUPPORT THE OVERALL GOAL OF THE ORGANISATION. THE TRANSFER PRICE SHOULD BE CHOSEN SO THAT EACH DIVISION MANAGER, WHEN STRIVING TO MAXIMIZE HIS OWN DIVISION’S PROFIT, MAKE THE DECISION THAT MAXIMIZE THE COMPANY’S PROFIT.
- 3. MANAGEMENT’S OBJECTIVE IN SETTING A TRANSFER PRICE IS TO ENCOURAGE GOAD CONGRUENCE AMONG THE DIVISION MANAGERS INVOLVED IN THE TRANSFER. A GENERAL RULE THAT WILL ENSURE GOAL CONGRUENCE IS GIVEN BELOW: T.P = VARIABLE COST OF + OPPORTUNITY PRODUCT PLUS COST TO THE ANY SPL OUTLAY COMPANY DUE TO TRANSFER DUE TO TRANSF.
- 4. IN APPLYING THE GENERAL TRANSFER PRICING RULE, WE WILL DISTINGUISH BETWEEN TWO DIFFERENT SCENARIOS. SCENARIO 1: NO EXCESS CAPACITY. SCENARIO 2: EXCESS CAPACITY.
- 5. THE GENERAL TRANSFER-PRICING RULE WILL ALWAYS PROMOTE GOAL CONGRUENCE DECISION MAKING, IF IT CAN BE IMPLEMENTED. THE RULE IS DIFFICULT TO IMPLEMENT IN CASE IT IS DIFFICULT TO MEASURE OPPORTUNITY COST. ONE REASON WHY OPPORTUNITY COST MAY BE DIFFICULT TO MEASURE IS THAT THE EXTERNAL MARKET MAY NOT BE PERFECTLY COMPETITIVE. SECOND REASON COULD BE THAT THE PRODUCT TRANSFERRED TO UNIQUE, NOT HAVING EXTERNAL MARKET. THIRDLY THE PRODUCT TRANSFERRED MAY BE MADE UP OF MORE THAN ONE PRODUCT/SERVICES MAKING IT DIFFICULT TO KNOW THE OPPORTUNITY COST OF EACH.
- 6. A COMMON APPROACH IS TO SET THE TRANSFER PRICE EQUAL TO THE PRICE IN THE EXTERNAL MARKET. WHEN THE PRODUCTION DIVISION HAS NO EXCESS CAPACITY AND PERFECT COMPETITION PREVAILS, THE GENERAL TRANSFER PRICE RULE AND EXTERNAL MARKET PRICE WILL YIELD THE SAME TRANSFER PRICE. IF THE PRODUCTING DIVISION HAS EXCESS CAPACITY AND PERFECT COMPETITION DOES NOT PREVAIL, THEN THE TWO METHODS WILL GIVEN DIFFERENT TRANSFER PRICES. IN CASE THIS SYSTEM IS FOLLOWING, BOTH THE PRODUCING AS WELL AS BUYING DIVISIONS SHOULD BE FREE TO SELL/BUY TO/FROM EXTERNAL MARKET.
- 7. DIVISION MANAGERS ACTUALLY NEGOTIATE THE PRICE AT WHICH THE TRANSFER WILL BE MADE. SOMETIMES THEY START WITH MARKET PRICE AND MAKE ADJUSTMENTS FOR VARIOUS REASONS. THIS METHOD IS USED SOMETIMES WHEN NO EXTERNAL MARKET EXISTS FOR THE PRODUCT. TWO DRAWBACKS OF THIS METHOD ARE -DIVISIVENESS AND COMPETITION BETWEEN DIVISION MANAGERS AND UNDUE WEIGHTAGE TO NEGOTIATING SKILLS OF A MANAGER IN APPRAISING HIS PERFORMANCE.
- 8. VARIABLE COST: UNDER THIS APPROACH VARIABLE COST IS SET AS THE TRANSFER PRICE. THE PROBLEM WITH THIS APPROACH IS THAT THE PRODUCING DIVISION IS NOT ALLOWED TO SHOW AND CONTRIBUTION ON THE TRANSFERRED GOODS, EVEN IF IT HAS EXCESS CAPACITY
- 9. UNDER THIS METHOD TRANSFER PRICE IS EQUAL TO VARIABLE COST OF THE PRODUCT PLUS AN ALLOCATED PORTION OF THE FIXED OVERHEADS. TRANSFER PRICE BASED ON FULL COST RUN THE RISK OF CAUSING DYSFUNCTIONAL DECISION MAKING BEHAVIOUR. THIS HAPPENS BECAUSE THE BUYING DIVISION PERCEIVES THE FIXED COST TO THE COMPANY AS A WHOLE AS VARIABLE COST TO THE BUYING DIVISION .
- 10. INCOME TAX RATES: MULTINATIONAL COMPANIES OFTEN CONSIDER DOMESTIC AND FOREIGN INCOME TAX RATES WHEN SETTING TRANSFER PRICES. IMPORT DUTIES: THESE DUTIES ALSO PLAY A ROLE IN SETTING TRANSFER PRICES IN CASE OF GOODS BEING TRANSFERRED TO OTHER DIVISIONS LOCATED IN DIFFERENT COUNTRIES .