Transfer Prices
Transfer prices Terminologies
Goal congruence ⇒ is the agreement on firm’s goals by individuals at all levels; performance is
maximized when all employees are working toward the same goal (the firm’s goals). Otherwise
suboptimization (impairment in goal congruence would occur).
Motivation ⇒ is the desire and commitment to achieve a specific goal.
Managerial effort ⇒ is the extent of the attempt to accomplish a specific goal. Managerial effort may include psychological as well as physical commitment to a goal.
Autonomy ⇒is the extent to which individuals have the authority to make decisions.
Transfer price
Transfer price is the price charged by one segment of an organization for a product or service
supplied to another segment of the same organization.
Transfer pricing sets prices for internally exchanged goods and services among internal
segments of the same organization.
An intermediate product is a good or service that is transferred between two segments of a
company.
Transfer pricing is most common in firms that are vertically integrated, i.e., they are engaged in
several different value-creating operations for a product.
Company strategy is greatly affected by choice of transfer prices. If the company wants the business units to behave independently and keep managers motivated to achieve company goals, transfer prices should be set at arm’s length (an impartial or fair market price), as if the party were any other external client. When no external suppliers or customers exist for a product or service the “arm’s length price is more difficult to determine. Then the amounts set for transfer prices require cooperation between many departments including finance, production, marketing, and tax planning.
Firms that have a high degree of vertical integration will need to carefully set transfer prices. For example, a corporation that owns farms, food warehouses, distributors, and grocery stores will need to set prices for each service that will be perceived fair by all segments and also allow each portion of their business to be financially flexible (decentralized).
The most fundamental responsibility center affected by the use of transfer prices, especially market based transfer prices is the profit center. But transfer prices are used to evaluate the performance of a profit center and an investment center.
Note : Intracompany profit must be eliminated from inventories when consolidated financial
statements and the income tax return are prepared.
The three basic criteria that the transfer pricing system in a decentralized company should satisfy are to :
- Provide information allowing central management to evaluate operating divisions with respect tototal company profit and each division’s contribution to profit, this promote congruence of subunits goals with the goal of the organization,
- Stimulate each manager’s efficiency without losing each division’s autonomy (encourage autonomous decision making)
- Motivate each divisional manager to achieve his/her own profit goal in a manner contributing to the company’s success. (Encourage managerial effort in a decentralized organization).
No specific rule exists for determining the transfer price that meets these criteria in all situations (i.e.,) no price formula is appropriate in all circumstances.