Page 299 - DMGT403_ACCOUNTING_FOR_MANAGERS

Accounting for Managers

Notes 14.5 Transfer Pricing

Large business units are usually organised into different divisions for better control. In such a
situation, if one division supplies its finished output as input to other division, there arises a
very important issue. The issue being at which price should be transferring unit transfer its
product or service. Such price is known as transfer price.
Transfer prices are the amounts charged by one segment of an organization for a product or
service that it supplies to another segment of the same organization.

Transfer price in simple words is the price that one sub-unit (segment, department, division and
so on) of an organization charges for a product or service supplied to another subunit of the
same organization. It is different from the normal price in that both divisions are a part of the
same organisation and therefore it is only an internal transfer and not sale. The pricing of these
flows is likely to have an impact on the performance evaluation of the divisions. Setting of
transfer pricing policies within the company is of great significance. The important issue now is
at what price should such transfers be made.

Did u know? Why do transfer-pricing systems exist?
1. To communicate data that will lead to goal-congruent decisions.
2. To evaluate segment performance and thus motivate managers toward goal-
congruent decisions.

3. Multinational companies use transfer pricing to minimize their worldwide taxes,
duties, and tariffs. Ideally, the chosen transfer-pricing method should lead each
subunit manager to make optimal decisions for the organization as a whole. The
three specific criteria that can help in choosing a transfer-pricing method are:
(a) Promotion of Goal Congruence: Goal congruence exists when each divisional or
sub-unit manager acting in his or her own best interest takes actions that
automatically result in achieving the organisation goals established by top
management.
(b) Promotion of a Sustained High Level of Management Effort: Effort is defined as
exertion towards a goal, for example, sellers are motivated to hold down costs
of supplying product or service, and buyers are motivated to acquire and use
inputs efficiently. The environment in the organisation should be such that a
sustained high level of management effort is promised.
(c) Promotion of a High Level of Subunit Autonomy in Decision-making: Autonomy is
the degree of freedom a division manager can exercise in decisions making. If
top management favours a high degree of decentralization, this criterion is of
particular importance.
Transfer pricing is a critical issue in the organisation. This is because the transfer
price decides:
4. The revenue of the supplying division thus influences divisional profit; and
5. The cost of the receiving division thus influences divisional profit.

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