Transfer-Pricing Methods

Transfer-Pricing Methods

There are three methods for determining transfer prices:
1. Market-based transfer prices. Top management may choose to use the price of a similar product or service publicly listed in, say, a trade association Web site. Also, top management may select, for the internal price, the external price that a subunit charges to outside customers.
2. Cost-based transfer prices. Top management may choose a transfer price based on the costs of producing the product in question. Examples include variable production costs, variable and fixed production costs, and full costs of the product. Full costs of the product include all production costs plus costs from the other business functions (R&D, design, marketing, distribution, and customer service). The costs used in cost based transfer prices can be actual costs or budgeted costs. Sometimes, the cost based transfer price includes a markup or profit margin that represents a return on subunit investment.
3. Negotiated transfer prices. In some cases, the subunits of a company are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with outside parties. Subunits may use information about costs and market prices in these negotiations, but there is no requirement that the chosen transfer price bear any specific relationship to either cost or market-price data. Negotiated transfer prices are often employed when market prices are volatile and change occurs constantly. The negotiated transfer price is the outcome of a bargaining process between the selling and buying subunits.
To see how each of the three transfer-pricing methods works, and to see the differences among them, we examine transfer pricing at Horizon Petroleum Inc. against the four criteria: goal
congruence, management effort, subunit performance evaluation‖ and subunit autonomy (if desired).