Transfer pricing -The basic principles of transfer pricing.

A transfer price is the price is “the price at which goods or services are transferred form one process or department to another or form one member of a group to another ,

Transfer pricing is used when divisions of an organization need to charge other divisions of the organization for goods or services they provide to them.

Three problems with transfer pricing.

Divisional autonomy
transfer prices are particularly appropriate for profit centers because if one profit center does work for another the size of the transfer price will affect the costs of one profit center and the revenues of another.

However, a danger with profit center accounting is that the business organization will divide into a number of self-interested segments, each acting at times against the wishes and interest of other segments. Decisions might be taken by a profit center manager in the best interests of his own part of the business, but against the best interest of other profit centers and possible the organization as a whole.

A task of head office is therefore to try to prevent dysfunctional decision making by individual profit centers. To do this, head office must reserve some power and authority for itself and so profit centers cannot be allowed to make entirely autonomous decision.

Just how much authority head office decides to keep for itself will vary according to individual circumstances. A balance ought to be kept between divisional autonomy to provide incentives and motivation, and retaining centralized authority to ensure that the organization’s profit centers are all working towards the same target, the benefit of the organization as a whole (in other words, retaining goal congruence among the organization’s separate divisions).

Divisional performance measurement.
profit centers managers tend to put their own profit performance above every this else. Since profit centers performance is measured according to the profit they earn, no profit center will want to do work for another an incur cost without being paid for it. Consequently, profit center managers are likely to dispute the size of transfer prices with each other, or disagree about whether one profit center should do work for another or not. Transfer prices affect behavior and decisions by profit center managers.

Corporate profit maximization.
When there are disagreements about how much work should be transferred between divisions, and how many sales the division should make to the external market, there is presumably a profit- maximizing level of output and sales for the organization as a whole. However, unless each profit center also maximizes

Its on profit at this same level of output , there will be inter divisional disagreements about output levels and the profit maximizing output will not be achieve.

The ideal solution.
Ideally a transfer price should be set at a level that overcomes these problems.

– The transfer price should provide an ‘artificial’ selling price that enables the transferring division to earn a return for its efforts. And the receiving division to incur a cost for benefits received.

– The a transfer price should be set at a level that enables profit center performance to be measured ‘commercially’. This means that the transfer price should be a fit commercial price.

– The transfer price, if possible, should encourage profit center managers to agree on the amount of goods and services to be transferred, which will also be at a level that I consistent with aims of the organization as a whole such as maximizing company profits.

In practice it is difficult to achieve all there aims

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