Transfer Pricing

The amount charged when one division sells goods or services to another division is called transfer price. 

The basic purpose of transfer pricing is to induce optimal decision making in a decentralized organization (i.e., in most cases, to maximize the profit of the organization as a whole).

Purposes of Transfer Pricing

There are two main reasons for instituting a transfer pricing scheme:

• Generate separate profit figures for each division and thereby evaluate the performance of each division separately.

• Help coordinate production, sales and pricing decisions of the different divisions (via an appropriate choice of transfer prices). Transfer prices make managers aware of the value that goods and services have for other segments of the firm.

• Transfer pricing allows the company to generate profit (or cost) figures for each division separately.

• The transfer price will affect not only the reported profit of each center, but will also affect the allocation of an organization’s resources.

Main objectives of a transfer pricing system

1. To achieve goal congruence: The transfer prices should be such that actions which will have the effect of increasing a division’s reported profit will also have the effect of increasing the company’s reported profit. This maximises the likelihood that the division managers will act in the company’s best interests.

2. To ensure that divisional autonomy is maintained: In principle the top management of a company could simply issue precise instructions to divisions as to what goods to transfer to each other, in what quantities, and at what prices. This would seem to solve the problem of transfer pricing at a stroke, and to achieve optimization (for the company as a whole) by diktat. However, most organizations are unwilling to go down this road, because of the enormous benefits of allowing divisional autonomy. It would be very difficult to make division managers accountable for their profits if they were not given a free hand in making important decisions.

3. To ensure that the information provided: (e.g., division Profit & Loss Accounts) is useful for evaluating the economic performance of divisions and the managerial performance of division managers.