In a large organization, a central management cannot monitor and control all the operation parameters of every subunit. For this reason, large organizations are usually separated into divisions. Each division is an autonomous unit and its manager has the freedom to take all necessary action. But a decentralized organization has difficulty evaluating the performance of the division managers. Furthermore, the central management of the organization needs to coordinate the actions of the divisions to maximize the organization‘s total profit. In order to evaluate the performance of each division, a method is needed for measuring the contribution of each division to the total profit of the organization. A common solution to this problem is to set prices for intermediate goods which are transferred from one division to another. These prices are known as transfer prices. Transfer prices are mainly used
1. To evaluate division managers‘ performance based on the profits that he generates,
2. To help coordinate the divisions‘ decisions to achieve the organization‘s goals – i.e., to ensure goal congruence
3. To enable the divisions to take decisions like the pricing of the final product,
4. To preserve divisions‘ autonomy.
In the classical Transfer Pricing (TP) problem, we usually think of two divisions in a decentralized organization. Division 1 produces an intermediate good and Division 2 transforms it into a final good and sells it in the market. Division 1 ―sells‖ a quantity of the intermediate good to Division 2 at a certain price. This price (the transfer price) is used to place a value on the transaction between the two divisions. The total transaction value is considered as income by the selling division and as expense by the buying division. This allows the net profits of the two divisions to be determined. The division managers are evaluated by the profits that their divisions generate, but the organization‘s objective is to maximize its total profit. The objectives of the organization and those of the division managers are often incompatible. There fore, the problem of the organization is to determine a pricing rule that serves its own goals, taking into account the objectives of the divisions. This is easy in a world of perfect information, where central management can calculate the optimal transfer prices. The problem is more difficult when there is asymmetry of information (i.e., some information is private). Division managers may wish to conceal some information, in order to manipulate the outcome in their own favor.
In practice the problem is still more complicated. In addition to the asymmetry of information, divisions may have multiple products or may face capacity constraints, the product may have to be manufactured by a chain of more than two divisions, some of the intermediate goods may also be sold in the market, etc. Let us briefly discuss the transfer pricing methods in common use today. We list here only some of the more common methods that appear in the accountancy literature. Cost methods: The transfer price is a certain function of the production cost of the selling division. It may or may not include a fixed cost component. There are several variations of this approach such as cost plus fixed fee, cost plus a fixed percentage of the cost, full cost plus markup, variable cost, marginal cost.
Market price methods: If there is a market for the intermediate good, then the market price is used as the transfer price. Often t he transfer price is the market price minus the selling expenses.
Dual price methods: The price that the selling division receives is not equal to the price that the buying division pays – and is usually higher. This mechanism generates a deficit, which is set off by central management. Because central management sets the optimal transfer price, and hence sets the transaction volume to be optimal, this mechanism yields higher performance than other methods. However, it is not commonly used because it requires central management to be involved in the complex process of price setting.
Negotiated transfer prices: The transfer price is reached by negotiation between the relevant division managers. The advantage of this method is that it preserves the divisions‘ autonomy. Its problem is the sensitivity of the outcome to the managers‘ negotiation skills.
Each method in this list can be applied in various ways. For example, the markup in the cost-plus method can be determined as a percentage of the cost, which equals a certain return on investment of either the division or the organization. The transfer pricing mechanism that an organization applies may have a critical impact on the organization‘s performance. Although the transfer-pricing problem has been studied for many years it is still considered an open problem.
In decentralized organizations, much of the decision-making power resides in its individual sub units. In these cases, the management control system often uses transfer prices to coordinate the actions of the subunits and to evaluate their performance.
A transfer price is the price one sub-unit (department or division) charges for a product or service supplied to another sub-unit of the same organization. It for example, a car manufacturer has a separate division that manufactures engines; the transfer price is the price the engine division charges when it transfers engines to the car assembly division. The transfer price creates revenues for the selling subunit (the engine division in our example) and purchase costs for the buying subunit (the assembly division in our example), affecting each subunit‘s operating income. These operating incomes can be used to evaluate subunit performance and to motivate their managers. The product or service transferred between subunits of an organization is called an intermediate product. This product may either be further worked on by the receiving subunit or, if transferred from production to marketing, sold to an external customer.
In one sense, transfer pricing is a curious phenomenon. Activities within an organization are clearly non-market in nature; products and services are not bought and sold as they are in open-market transactions. Yet, establishing prices for transfers among subunits of a company has a distinctly market flavor. The rationale for transfer prices is that subunit managers (such as the manager of the engine division), when making decisions, need only focus on how their decisions will affect their subunit‘s performance without evaluating their impact on company wide performance.In this sense, transfer prices ease the subunit managers‘ information-processing and decision-making tasks. In a well designed transfer-pricing system, optimizing subunit performance (the performance of, the engine division) leads to optimizing the performance of the company as a whole.
As in all management control systems, transfer prices should help achieve a company‘s strategies and goals and fit its organization structure. In particular, they should promote goal congruence and a sustained high level of management effort.
Subunits selling a product or service should be motivated to hold down their costs; subunits buying the product or service should be motivated to acquire and use inputs efficiently. The transfer price should also help top management evaluate the performance of individual subunits and their managers. If top management favors a high degree of decentralization, transfer prices should also promote a high degree of subunit autonomy in decision-making.
That is, a subunit manager seeking to maximize the operating income of his or her subunit should have the freedom to transact with other subunits of the company (on the basis of transfer prices) or to transact with outside parties.