10.2 Transfer Pricing Methods

Transfer pricing is crucial for internal exchanges in decentralized companies. It affects division performance and company-wide efficiency. Methods include market-based, cost-based, negotiated, and dual pricing, each with pros and cons.

Choosing the right method involves balancing fairness, motivation, and overall company goals. Factors like opportunity cost, marginal cost, and full cost play key roles in setting effective transfer prices that align division and company interests.

Transfer Pricing Methods

Market-Based and Cost-Based Transfer Pricing

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• Transfer pricing determines the price at which goods or services are exchanged between divisions within a company
• Market-based transfer pricing uses external market prices as a reference point for internal transfers
  • Reflects the true economic value of the product or service
  • Encourages divisions to be competitive with external markets
  • Can be challenging when no clear external market exists
• Cost-based transfer pricing sets prices based on the production costs of the transferring division
  • Typically includes variable costs plus a markup for fixed costs and profit
  • Easy to implement when cost information is readily available
  • May not provide incentives for efficiency in the transferring division

Negotiated and Dual Transfer Pricing

• Negotiated transfer pricing allows divisions to bargain and agree on a price
  • Promotes autonomy and can lead to optimal outcomes for both divisions
  • Requires good faith negotiations and may be time-consuming
  • Can be influenced by the relative bargaining power of each division
• Dual pricing system uses different prices for the selling and buying divisions
  • Selling division receives market price, buying division pays full cost
  • Aims to motivate both divisions while avoiding conflict
  • Can be complex to implement and may lead to inconsistencies in financial reporting

Cost Considerations

Opportunity Cost and Marginal Cost

• Opportunity cost represents the value of the next best alternative forgone
  • Critical in transfer pricing decisions to ensure optimal resource allocation
  • Helps determine whether internal transfers are more beneficial than external sales
  • Can be difficult to quantify, especially for intangible goods or services
• Marginal cost refers to the additional cost incurred to produce one more unit
  • Often used as a minimum transfer price in cost-based systems
  • Encourages efficient production and resource utilization
  • May not cover fixed costs or provide profit for the transferring division

Full Cost and Cost-Plus Pricing

• Full cost includes all direct and indirect costs associated with producing a good or service
  • Ensures all costs are recovered in the transfer price
  • May lead to overpricing if the buying division can obtain the item cheaper externally
  • Can result in the "death spiral" if used exclusively for transfer pricing
• Cost-plus pricing adds a markup to the full cost to provide a profit for the transferring division
  • Markup can be a fixed amount or a percentage of costs
  • Provides incentive for the transferring division to continue internal sales
  • May lead to inefficiencies if the markup is not carefully determined
  • Requires periodic review to ensure the markup remains appropriate