Choosing Transfer Price Models

The transfer pricing system must accomplish the following:

• It must give senior management the information it needs to evaluate the performance of the profit centers.
• It must motivate the profit center managers to pursue their own profit goals while also
  working toward the success of the company as a whole.
• It must encourage the cost efficiency while maintaining manager’s autonomy.
• It must be equitable, permitting each unit of a company to earn a fair profit for the functions it performs.
• It must meet legal and external reporting requirements.
• It should be easy to apply.

Choosing Transfer Price Models

In general, the market price method is preferred in situations when the market price for a good
or service is available. When a market price is not available, the negotiated price method is
preferred. When neither is acceptable, companies may turn to one of the cost models. Actual
Cost based methods are not recommended because they can lead to motivation problems
between parties such as the seller not actively controlling costs because they are simply passed on to the buyer.

The logic of choosing a transfer price model and setting transfer prices starts with a make or
buy decision. If there are outside suppliers for a product or service, then the market price model
should be used. The company should compare the selling unit’s variable costs to the market
price for the external substitute. If the external market price is lower than the internal variable
cost, the buyer should purchase externally to motivate the internal supplier to find ways to
lower costs.

When the internal variable cost is less than the external market price, then the buying unit
should purchase internally, as long as the selling unit has excess capacity. The variable cost
model is best for low capacity, and the market price model is best for high capacity. If the
selling unit is at full capacity, the buying unit should purchase externally, as long as the selling
unit can generate more profit from a sale to an external source than will be lost if the buying
unit pays the external market price for the item. When the opposite is true, the buying unit
should purchase internally and pay market price for the item.