Business organizations are made up of different units. Management holds these units accountable for their expenses and the profits they generate. The different units sometimes engage in transactions with each other. For instance, one unit could supply raw material to another unit. Various transfer pricing methods, such as cost-based transfer pricing, help deal with such situations.
Transfer pricing is the price that one business unit of a firm charges another business unit for the goods or services it provides. There is no actual exchange of cash between the two units. The price, used for internal record-keeping purposes, serves to provide an idea about what one unit owes the other for the service or good provided. When the two units are located in different countries, tax issues also arise.
Provides Better Clarity
The use of transfer pricing helps provide management with better clarity about the performance of a business unit. For instance, if one unit gets raw material from another unit and is not assessed a price, it might seem as though the receiving unit is highly profitable. If the receiving unit had purchased the raw material from an outside vendor, it would have paid a purchase price that would have reduced its profit. Thus, factoring in a transfer price helps provide better clarity for management.
Transfer pricing helps assess the profitability of a particular unit within the company. Generally, businesses gauge the profitability of a business unit that is set up as a profit center in terms of the profit it generates. By using transfer pricing methods to get the complete picture of a unit’s activities and profit generation, management is able to better evaluate the performance of the different unit managers.
There has to be internal coordination among the different units of an organization. Transfer pricing helps the different units coordinate their business activities. For instance, the unit that gets the raw materials gets the same amount of debit for the units it receives as the credit that the transferring unit gets. This mechanism helps the two units better coordinate their pricing activities. As well, it helps them coordinate their production and sales activities.