Transfer pricing is when the business divisions are treated as separate entities so that the price charged by one part of the company from another part of the same company in order to provide them with certain service is known as transfer pricing. It lets the business calculate the profit and loss of each part or division separately. There are usually two main purposes when a company chooses to practice transfer pricing. The first one is as mentioned earlier to calculate the profit and loss of divisions separately thus evaluate their performance separately too. The second one to improve coordination between the departments like sales, marketing, finance etc by making them realise the worth products have for different departments. This practice might even help the allocation of resources more efficiently.
The methods of transfer pricing are broadly divided in to three main categories. The first being market based transfer pricing, this is when the general market for product is in a stable form and competitive so the firm uses the market price as ceiling for transfer price. The second is Negotiated transfer pricing, in this case company does not set a specific price but leaves it onto the departments’ heads to coordinate and agree on an acceptable price to both. The last is the Cost based transfer pricing, which in the absence of a fixed market price is based on the cost of its supply. Its sub divided into full cost, cost plus, variable cost plus lump sum charge, variable cost plus opportunity cost and dual transfer pricing.
Transfer pricing is a decentralised form of managing the company. So it brings the advantages like the central management does not have to worry about every little problem any department faces. The managers of departments are better motivated as they have responsibility of their unit which will be judged against others. It may also improve the decision making process as local managers are more aware of local conditions than the central management is. It also has it’s drawbacks like the communication amongst the departments may get too inefficient as they become more independent, transfer pricing may even increase costs of business.
All the ways, pros and cons of transfer pricing need to be weighed before a company can implement it.