TRANSFER PRICING

A company may operate with multiple segments, and in doing business, may transfer assets from one segment to another. The transfer price is that price charged to provide goods or services to another segment of the business. There are at least three types of businesses, where transfer pricing is commonday: Mining, Processing & Manufacturing.

Transfer pricing can become difficult when products are upgraded at each stage within the company, and outside customers are serviced simulataneously. Each segment is cautious about it´s transfer cost because it has an effect on that segment´s overall rate of return.  Market prices are used as a determinant of cost as well as prices achieved through negotiation (investment + profit centers), or at cost (Variable or Full [absorbtion] cost).

Transfer Prices at Cost

Costs net of profit are computed where possible [Variable], with the possibility of a fixed cost [Absorbtion]prorated based on some measure of consideration. Although, many companies prefer this method since it is easy to apply, one drawback is that this method does not tell managers when and when not to make the transfers between segments. The other defect of using the Cost Method is that only the segment that makes the sale, shows a profit. ROI is distorted since residual income is imperfect, and managers have less incentive to control costs, since they can easily be passed on to another segment.

To avoid inefficiency, and impede an additional burden on the point of sale where the transfer takes place, divisions should provide incentives to control costs, such as costs for tracking transfer and selling.

If transfer pricing is quite common, it makes sense to keep to standard prices rather than actual costs. With perfect information it is possible to set a fair price for transfer as follows:

1. Minimum transfer price = Opportunity cost of transfer
2. Minimum transfer price = Marginal production cost + Other opportunity costs
3. Minimum transfer price = Marginal or variable production costs + Lost contribution margin

Application of this formula helps management to make efficient decisions. Is it cheaper to buy from within the company or purchase from an external supplier.

Transfer Prices at Market Price

If prices are used which can be had on the market, there is a greater liklihood that all divisions or segments will show a profit (providing there is in fact one) as opposed to one single unit allowing for the transfer to proceed. This method also provides a more competitive way of doing business, such as is the case in arms-length transactions where bargaining is possible.

Using the market rate as the basis for transfer is an excellent way for managers to show their prowess in making optimal decisions based on cost. This is especially true, if managers can show that they can offer a price that is below market price (cost savings).

Disagreements may still arise if the selling department does not want to sell or rejects the price offered to make the transfer. This may happen if the different departments operate in different markets or customer loyaties would be infringed upon due to lower output or availability of products available for sale.

Saavy managers know not only what is the marginal cost to produce an additional unit, but also the opportunity cost of forfeiting a sale to an external customer.