Transfer pricing decisions are strategically important in business because organizations expend a lot of time, effort, and resources to formulate their transfer prices. The transfer price charged for an internal transaction between divisions can have an impact on both divisional and individual managers’ performance. Consequently, transfer-pricing decisions relating to sourcing and establishing costs have implications for the financial performance of both the internal buyer and internal suppliers.
Practitioners need to be aware of the impact that transfer-pricing decisions have on the financial performance of divisions within a decentralized organization. The transfer price plays a pivotal role in business, as it is a cost to the buying division and a source of revenue to the selling division and so impacts on the financial performance of both divisions. However, the transfer price also acts as an important benchmark when a buying division is faced with internal or external alternative sources of supply for a product.
In today’s business, organizations often have more than one internal source of supply for an identical intermediate product. This raises a number of important issues regarding the internal sourcing decision for the buying division and the setting of the transfer price for the supplying division. For example, does the division buy in the component externally or stay with the internal supplier? The major issue facing the internal supplier is the transfer price to be charged for an intermediate product.
Understanding the typical management issues relating to transfer pricing and managing the relationships between divisional business units as well as the center is crucial. Sometimes management decisions can clash with the objectives of introducing transfer pricing, and conflict can arise.
The Accenture Academy course Managing Transfer Pricing and Firm Performance offers examples of different transfer pricing decisions and examines the impact of the transfer pricing decision on the financial performance of the parties involved in the internal transaction.
It All Adds Up: Understanding the Effects of Transfer Pricing
If you have ever lived with a roommate, you may recognize how difficult it is to fairly divide common resources. Splitting general overhead costs such as rent or utilities might not have been difficult, but if one of you paid for an item the other frequently used, did you work out a system for sharing the cost?
In business, it is imperative to determine the costs associated with internal transactions and charge appropriate fees—that is, to include accurate transfer pricing in the total cost of operations. Within a decentralized organization, such as when a company creates an internal market between its manufacturing and marketing divisions, you must recognize the impact of transfer pricing and its effects on both divisional and individual managers’ performance. To the buying division, it is a cost; to the selling division, it is a revenue source. Your company must record and report both the cost and the revenue in accordance with relevant tax laws.
So how do you determine fair transfer pricing? Many procurement transactions occur at arm’s length: two unrelated companies work out an arrangement between the buyer and the seller. One method for determining transfer prices is to set them close to the fees an external seller would charge. Another method is to determine how much other companies charge for similar products.
Companies also commonly have multiple sources of internal supply, and you must handle the conflicts that arise when choosing a supplier and fixing full-cost-plus transfer prices. As well, you must determine if you can achieve a better price using an external supplier. By thoroughly examining your internal supplier structure and all associated costs, you will understand better how your decisions affect the financial performance of the various divisions.
In addition, problems may arise between the central office of the business and its divisions because of miscommunications or conflicting goals. Your awareness of how to use transfer pricing as a performance measurement for managers can help your company to synchronize goals between the parent and its subsidiaries and avoid territorial disputes.
Does your company have a strong system for handling the issues surrounding transfer pricing? The Accenture Academy course Managing Transfer Pricing and Firm Performance offers examples of different transfer pricing decisions and examines their effects on the internal financial performances of fictional businesses to illustrate how to make sound, informed choices for your organization.