What is Transfer Pricing, When It is Important?
Simply put, transfer pricing is a task of determining prices at which products (or could be components) will be sold between divisions (or department or business units) in a corporation. It is most common in vertically integrated companies, where each division in succession produces a component that is a necessary part of the product being created by the next division in line.
So, if an organization sells its own products internally—from one division to another—then transfer pricing is important.
There are five transfer pricing techniques a corporation can choose from to improve profitability of not only business unit level, but the corporate-wide level. Each of the technique has strengths and weaknesses that, any incorrect transfer pricing can cause considerable dysfunctional purchasing behaviour and could suffer profitability on corporate-wide level—thus selecting the most suitable transfer pricing techniques is critical.
First, here s a quick comparison of the five transfer pricing techniques, each shows four variables: profitability enhancement, performance review process required, ease of use and common problems.
Five Transfer Pricing Techniques Summarized
A comparison of five transfer pricing methods can be summarized as follows:
1. Market Pricing
- Profitability Enhancement: Creates highest level of profits for entire company.
- Performance Review: Creates profits centres for all divisions.
- Ease of Use: Simple applicability.
- Problems: Market prices not always available; may not be large enough external market; does not reflect slight reduced internal selling costs; selling divisions may deny sales to other divisions in favor of outside sales.
2. Adjusted Market Pricing
- Profitability Enhancement: Creates highest level of profits for entire company.
- Performance Review: Creates profits centres for all divisions.
- Ease of Use: Requires negotiation to determine reductions from, market price.
- Problems: Possible arguments over size of reductions; may need headquarters’ intervention.
3. Negotiated Prices
- Profitability Enhancement: Less optimal result than market-based pricing, especially if negotiated prices vary substantially from the market.
- Performance Review: May reflect manager negotiating skills more than division performance.
- Ease of Use: Easy to understand but requires substantial preparation for negotiations.
- Problems: May result in better deals for divisions if they buy or sell outside the company; negotiations are time consuming; may require headquarters’ intervention.
4. Contribution Margins
- Profitability Enhancement: Allocates final profits among cost centres; divisions tend to work together to achieve large profit
- Performance Review: Allows for some basis of measurement based on profits, where cost centre performance is only other alternative.
- Ease of Use: Can be difficult to calculate if many divisions involved.
- Problems: A division can increase its share of the profit margin by increasing its costs; a cost reduction by one division must be shared among all divisions; requires headquarters’ involvement.
5. Cost Plus
- Profitability Enhancement: May result in profit build-up problem, so that division selling externally has no incentive to do so.
- Performance Review: Poor for performance evaluation, since will earn a profit no matter what cost is incurred.
- Ease of Use: Easy to calculate profit add-on.
- Problems: Margins assigned do not equate to market-driven profit margins; no incentive to reduce costs.
This post further discusses each of the transfer pricing techniques in greater details and provides guidance on how to make use of each technique—and improve profitability on the corporate-wide level, instead of department-or-business unit level.
Technique#1. Using External Market Price
Using external market price as transfer pricing technique is the most common. Under this approach, the selling division matches its transfer price to the current market rate. By doing so, a company can achieve four goals:
- Goal#1. Maximize profits – A company can achieve the highest possible corporate-wide profit. This happens because the selling division can earn just as much profit by selling all of its production outside of the company as it can by doing so internally—there is no reason for using a transfer price that results in incorrect behaviour of either selling externally at an excessively low price or selling internally when a better deal could have been obtained by selling externally.
- Goal#2. Profit centre structure – Using the market price allows a division to earn a profit on its sales, no matter whether it sells internally or externally. By avoiding all transfers at cost, the senior management group can structure its divisions as profit centres thereby allowing it to determine the performance of each division manager.
- Goal#3. Simplified information sources – The market price is simple to obtain—it can be taken from regulated price sheets, posted prices, or quoted prices, and applied directly to all sales. No complicated calculations are required, and arguments over the correct price to charge between divisions are kept to a minimum.
- Goal#4. Outside shopping – A market-based transfer price allows both buying and selling divisions to shop anywhere they want to buy or sell their products. For example, a buying division will be indifferent as to where it obtains its supplies, for it can buy them at the same price, whether that source is a fellow company division or not. This leads to a minimum of incorrect buying and selling behaviour that would otherwise be driven by transfer prices that do not reflect market conditions.
However, market prices are not always available. This happens when the products being transferred do not exactly match those sold on the market, or if they are intermediate- level products that have not yet been converted into final products, so there is no market price available for them.
Another problem with market-based pricing is that there must truly be an alternative for a selling division to sell its entire production externally. This is a common problem for speciality products, where the number of potential buyers is small, and their annual buying needs are limited in size. A final issue is that market-based pricing can drive divisions to sell their production outside of the company.
Technique#2. Using Adjusted Market Pricing
Adjusted market pricing involves price setting in order to simplify transfer prices and adjust for the absence of sales-related costs. For example, if market prices vary considerably by the unit volume ordered, there may be a broad range of transfer prices in use, which can be very complicated to track.
A single adjusted market price can be used instead, which is based on the average shipment or order size. If a buying division turns out to have purchased in significantly different quantities from the ones that were assumed at the time prices were set, a company can retroactively adjust transfer prices at the end of the year; or it can leave the pricing alone and let the divisions do a better job of planning their inter-divisional transfer volumes in the next year.
As another example, there should be no bad debts when selling between divisions, as opposed to the occasional losses incurred when dealing with outside firms; accordingly, this cost can be deducted from the transfer price.
The same argument can be made for the sales staff, whose services are presumably not required for interdepartmental sales. However, these price adjustments are subject to negotiation, so more aggressive division managers are more likely to resist reductions from their market-based prices while those managing the buying divisions will push hard for excessively large price deductions. The result may be pricing anomalies that do not yield the optimum profit for the company as a whole.
Technique#3. Using Negotiated Transfer Prices
The managers of buying and selling divisions can negotiate a transfer price between themselves, using a product’s variable cost as the lower boundary of an acceptable negotiated price and the market price (if one is available) as the upper boundary. The price that is agreed on, as long as it falls between these two boundaries, should give some profit to each division, with more profit going to the division with better negotiating skills.
The method has the advantage of allowing division managers to operate their businesses in a more independent manner, not relying on preset pricing. It also results in better performance evaluations for those managers with greater negotiation skills.
However, it also suffers from these flaws:
- Sub-optimal behavior – If the negotiated price excessively favors one division over another, the losing division will search outside the company for a better deal on the open market and will direct its sales and purchases in that direction; this may result in sub-optimal company-wide profitability levels.
- Negotiation time – The negotiation process can take up a substantial proportion of a manager’s time, not leaving enough for other management activities. This is a particular problem if prices require constant renegotiation.
- Brokered deals – Inter divisional conflicts over negotiated prices can become so severe that the problem is kicked up corporate headquarters, which must step in and set prices that the divisions are incapable of determining by themselves.
For all these reasons, the negotiated transfer price is a method that is generally relegated to special or low-volume pricing situations.
Technique#4. Using Contribution Margin
What if there is no market price at all for a product? A company then has no basis for creating a transfer price from any external source of information, so it must use internal information instead.
One approach is to create transfer prices based on a product’s contribution margin. Under this pricing system, a company determines the total contribution margin earned after a product is sold externally and allocates this margin back to each division, based on their respective proportions of the total product cost.
There are several good reasons for using this approach, which:
- Converts a cost center into a profit center – By using this method to assign profits to internal product sales, divisional managers are forced to pay stricter attention to their profitability, which helps the overall profitability of the organization.
- Encourages divisions to work together – When every supplying division shares in the margin when a product is sold, it stands to reason that it will be much more eager to work together to achieve profitable sales rather than bickering over the transfer prices to be charged internally. Also, any profit improvements that can be brought about only by changes that span several divisions are much more likely to receive general approval and cooperation under this pricing method, since the changes will increase profits for all divisions. These arguments make the contribution margin approach popular as a secondary transfer pricing method, after the market price approach.
Despite its useful attributes, there are a number of issues with it that a company must guard against in order to avoid behavior by divisions that will lead to less-than optimal overall levels of profitability. The contribution margin approach:
- Can increase assigned profits by increasing costs – When the contribution margin is assigned based on a division’s relative proportion of total product costs, the divisions will realize that they will receive a greater share of the profits if they can increase their overall proportion of costs.
- Must share cost reductions – If a division finds a way to reduce its costs, it will receive an increased share of the resulting profits that is in proportion to its share of the total contribution margin distributed. For example, if Division A’s costs are 20% of a product’s total costs and Division B’s share is 80%, then 80% of a $1 cost reduction achieved by Division A will be allocated to Division B, even though it has done nothing to deserve the increase in margin.
- Requires the involvement of the corporate headquarters staff – The contribution margin allocation must be calculated by somebody, and since the divisions all have a profit motive to skew the allocation in their favor, the only party left that can make the allocation is the headquarters staff. This may increase the cost of corporate overhead.
- Results in arguments – When costs and profits can be skewed by the system, there will inevitably be arguments between the buying and selling divisions, which the corporate headquarters team may have to mediate. These issues detract from an organization’s focus on profitability.
The contribution margin approach is not a perfect one, but it does give companies a reasonably understandable and workable method for determining transfer prices. It has more problems than market-based pricing but can be used as an alternative or as the primary approach if there is no way to obtain market pricing for transferred products.
Technique#5. Using Cost-Plus Method
The cost-plus approach is an alternative when there is no market from which to determine a transfer price. This method is based on its name—just accumulate a product’s full cost and add a standard margin percentage to the cost; this is the transfer price. This approach has the singular advantage of being very easy to understand and calculate, and can convert a cost center into a profit center, which may be useful for evaluating the performance of a division manager.
The cost-plus method’s flaw is that the margin percentage added to a product’s full cost may have no relationship to the margin that would actually be used if the product were to be sold externally. If a number of successive divisions were to add a standard margin to their products, the price paid by the final division in line—the one that must sell the completed product externally—may be so high that there is no room for its own margin, which gives it no incentive to sell the product. Because of this issue, the cost-plus method is not recommended in most situations.
Words of Caution
A company must set its transfer prices at levels that will result in the highest possible levels of profits, not for individual divisions but rather for the entire organization. Otherwise a division may enjoy maximum profit while the corporate-wide level does not.
For example, if a transfer price is set at a product’s cost, the selling division would rather not sell the product at all, even though the buying division can sell it externally for a profit that more than makes up for the lack of profit experienced by the division that originally sold it the product. The typical division manager will select the product sales that result in the highest level of profit only for his or her division, since the manager has no insight (or interest) in the Financial results of the rest of the organization.
Only by finding some way for the selling division to also realize a profit will a company have an incentive to sell its products internally, thereby resulting in greater overall profits.
An example of such a solution is when a selling division creates a by-product that it cannot sell but that another division can use as an input for the products it manufactures. The selling division scraps the by-product, because it has no incentive to do anything else with it. However, by assigning the selling division a small profit on sale of the by product, it now has an incentive to ship it to the buying division. Such a pricing strategy assists a company in deriving the greatest possible profit from all of its activities.
Another factor is that the amount of profit allocated to a division through the transfer pricing method used will impact its reported level of profitability—therefore the performance review for that division and its management team.
If the management team is compensated in large part through performance-based bonuses, its actions will be heavily influenced by the profit it can earn on inter-company transfers. For example, an excessively low transfer price will result in low production priority for that item, as long as the selling division has some other product available that it can sell for a greater profit.
Finally, altering the transfer price used can have a dramatic impact on the amount of income taxes a company pays, if it has divisions located in different countries that use different tax rates.
Companies that are frequent users of transfer pricing must create prices that are based on a proper balance of the goals of overall company profitability, divisional performance evaluation, and (in some cases) the reduction of income taxes. The attainment of all these goals by using a single transfer pricing method should not be expected. Instead, focus on the attainment of the most critical goals, while keeping the adverse affects of not meeting other goals at a minimum. This process may result in the use of several transfer pricing methods, depending on the circumstances surrounding each inter-divisional transfer.