Page 108 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 5: Transfer Pricing

the revenue that is generated when the product is finally sold. The transfer price is not primarily Notes
an accounting tool. Rather, it is a behavioural tool that motivates managers to take the right
decisions.

5.1.1 Objectives of Transfer Pricing

In particular, transfer price should be designed in such a way that it can accomplish the following
objectives:
1. It should provide each segment with the relevant information required to determine the
optimum trade-off between company costs and revenues.
2. It should induce goal congruence decisions i.e., the system should be so designed that
decision improves business unit (divisional) profits it will also improve company profit.
3. It should help determine the economic performance of the individual profit centres as
accurately as possible.
4. The system should be simple to understand and easy to administer.

5.2 Market Price as Transfer Price

Where the intermediate market is competitive and where interdependencies of subunits are
minimal, market price is the most desirable transfer price because it generally leads to optimum
decisions. There are no inherent conflicts in solving all three problems (goal congruence, incentive
and autonomy). The guidelines are (a) a market or negotiated market price should be used
(b) the seller should have the option of not selling internally i.e., the seller might have more
profitable alternative opportunities for using the facilities to sell other products (c) an arbitration
procedure should be available for settling disputes.
In many instances, a lower price may easily be justified, particularly when large purchases are
made, when selling costs are less, or when an advantage is obtained through an exclusive
supplier contract through a cost-plus arrangement assuming profits in all cases. These situations
lead to negotiated market prices (whereby the cost savings to the firm as a whole are split
between the selling and buying divisions through bargaining.

5.2.1 Pitfalls in Market Prices

Few markets are perfectly competitive or that no intermediate market exists for the exact product
or service in question. Moreover, isolated price quotations are sometimes temporary distress or
dumping prices for excess inventories that must be quickly liquidated in financial emergencies.

Many product parts are unique, a situation that causes considerable costs for preparing bids. If
an outside supplier prepares a few bids and discovers that the internal supplier division always
wins, the so-called resulting market prices either will not be forthcoming in future or will be
unreliable.

Notes If there is idle capacity, incongruent decisions may be caused by rigid adherence to
a market price.

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