Transfer pricing is used to set the internal price of goods and services that move between the divisions or business units of a corporation. Transfer pricing is used throughout the corporate world and impacts performance management, cost management and taxation.
The extensive use of transfer pricing has management, financial and tax implications for corporations. For example, low transfer pricing can make a division’s financial performance look better than it might be if it had to pay open market prices for its inputs. Unusually high transfer pricing can cause a purchasing division’s taxable income to be lower than it might ordinarily be, while the selling division will have inflated profits.
Transfer pricing serves an internal function, because when the divisions and business units of a corporation combine their financial statements the internal costs and revenues cancel each other out. Transfer pricing’s function is to establish agreed upon costs and revenues for the interaction that occurs within a company.
There are several types of transfer pricing methodologies. Market price approaches use real information from outside the company to set transfer prices. Economic approaches involve selling from one division to another at actual cost, plus an estimate of the opportunity cost created by not selling the goods or services externally. Full-absorption transfer pricing usually lies somewhere between a full market price and the real marginal cost internal to the firm. Cost-plus transfer pricing takes actual cost and adds a margin to simulate a market price.
The most important considerations involve the impact transfer pricing has on the operations of a corporation. If transfer pricing is not well designed, and made transparent throughout the firm’s management, then it can harm business decision making. For example, poor transfer pricing policies can cause specific divisions to unrealistically price their products and services to the external market.
The benefit to a well-designed transfer price approach is that it assists management in its price setting strategies. It can also be useful when there is excess capacity or inventory within a company that might be used internally to good benefit.