A transfer price is the price charged for transfer of goods or services between divisions of an organization. Transfer prices are an essential feature of decrentralised organizations where there are movements of products or services between profit and investment centers.
Generally, there are four basic approaches to transfer pricing, including:
1. Market based transfer prices;
2. Full cost transfer prices;
3. Cost-plus a mark-up transfer prices; and
4. Negotiated transfer prices.
Market based transfer price
Market based transfer prices is the price at which the product or services could be purchased by the receiving department in the external market place. In fact, for the intermediate product which a highly competitive market exists, it seems that the market price is the best possible transfer price should be chosen by the organisation because it cannot be abused as easily as the other approaches. Therefore, internal policy decisions to buy and sell the products or services internally will not significantly affect the evaluation of the performance of the divisions and managements. In addition, cost saving can be achieved by saving on selling expense, deliver costs and warranty terms when transferring internally. Moreover, the closure of the production division will not affect the selling division’s profit. In addition, divisions within the organization can make independent decisions. The optimal decisions in the best interest of the firm are most likely to be made without significant central office intervention.
However, there are some disadvantages for the market based transfer prices. For example, excess or shortage of capacity for the intermediate goods may exist in the market. In this situation, the selling division may b selling externally, while the buying division is unable to obtain all its requirements externally. The result may be that total company profits are not maximized, because the buying division’s output is being...