In managerial accounting, when different divisions of a multi-entity company are in
charge of their own profits, they are also responsible for their own "Return on
Invested Capital". Therefore, when divisions are required to transact with each
other, a transfer price is used to determine costs. Transfer prices tend not to differ
much from the price in the market because one of the entities in such a transaction
will lose out: they will either be buying for more than the prevailing market price or
selling below the market price, and this will affect their performance.
(i) Market-based transfer prices
(ii) Full-cost based transfer prices
(iii) Negotiated transfer prices
Market conditions which are appropriate for adoption are
generally appropriate in a perfect market, where there is
homogeneous product with only one price for both sellers
and buyers and no buying or selling costs.
The adoption of market-based transfer price in a
perfectly competitive market meet the criteria of a good
transfer price, that is it will promote goal congruent
decisions, preserve divisional autonomy and provide an
equitable basis for performance evaluation.
Market conditions which are appropriate for adoption in an
imperfect market, it may be unwise to always set transfer price
exactly at the variable costs of production, as such prices do not
provide for the replacement of fixed assets.
The Supply Division (SD) will want to base the transfer price on total
absorption cost to ensure that it will provide a contribution to cover
the fixed overheads.
In this situation, it is more appropriate to adopt negotiated transfer
prices. If both managers had been provided with all the information
and were educated to use information correctly, it is likely that a
negotiated solution would have emerged which would have been
acceptable to both the divisions and the group.
• When there is unused capacity, the transfer price range for
negotiations generally lied between the minimum price at which SD
is willing to sell (its marginal cost) and the maximum price BD is
willing to pay (the external supplier price net off any external
purchase related costs).
The importance of transfer pricing from the perspective of tax
authorities relates to the fact that the setting of prices for the
provision of services or the sale of tangible or intangible property
has a significant impact on the profitability of the local entity or
entities which is the basis for local tax determination. For this
reason, tax authorities in multiple jurisdictions have increased
control mechanisms to evaluate intercompany transactions.
A great number of countries uses transfer pricing as a mechanism
to allocate benefits within a multinational group with the ultimate
goal to ensure taxable basis protection, especially that of
jurisdictions with higher tax rates.