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A transfer price is the rupee basis used to quantify the transfer of goods or services from one responsibility center to another.
Purpose of Transfer Pricing:
When there is a transfer of goods or services take place between responsibility and an external party, then demand and supply forces determine the price that the seller has to receive and buyer has to pay, if the transaction takes place according to microeconomic rules. However, if there is exchange of goods between responsibility center and internal party, it causes more problem than in the case of performance evaluation. So transfer pricing help us to determine the price on which goods or services are to be exchanged between relative parties.
Top level management always ants that whether there is a transfer between responsibility center and external party or internal party, it should always be in best interest of the company.
Transfer Pricing Methods:
Market Based Transfer Prices:
In case, when their exist a competitive market price of the product of profit center, then the market price in such case is considered to be the best price charged to the product. Many economists and accountants believe today that market price is the best measure to determine the economic value of the good or service being transferred.
There may not be adequate incentives for the selling profit center if actual full cost or actual variable cost is being used as a transfer price. The use of standard costs would not fully eliminate the problem of transferring variances although they would lessen it up to certain level. If the variable cost is set as a transfer price, it would led to goal congruence. A full cost transfer price initially sends a correct signal to the buying profit center at first glance so that it can take best action in its best interests as well as best interests of the company.
Cost plus Mark-up:
This method is usually used to overcome the performance evaluation problems that are being associated with transfer prices that are set equal to full cost or variable cost. It is also considered as a practical approach for the problem of corporate profits and divergent profit center. In this case, although the transfer prices are higher than full cost, it will be in the best interests of the buying profit center and also to the company as a whole to transfer the product within the company.
The performance evaluation process is most likely to be satisfied by this method of transfer pricing. Negotiated price when settled between the managers of the buying and selling profit centers gives them the greatest control over profit. However, one problem with this pricing method is that it takes a long time and requires lot many data and analysis as there are frequent requests of price revision.
Proposals for Resolving Transfer Pricing Conflicts:
Generally, transfer pricing conflicts can be sort out by using the following techniques:
a) Dual Transfer Pricing System
b) Marginal Cost plus lump sum Fee
a) Dual Transfer Pricing System:
Usually, it would not be possible to have a single transfer price. Both buying and selling profit centers have their own interests in relevant transfer price. In this method, buying profit center is charged the market price whereas selling profit center is charged variable cost or a full cost plus a mark-up. As a result, income of the company would be less than the total income of the profit centers.
b) Marginal Cost plus lump Sum Fee System:
When the market for the product is not perfect and the selling profit center has no capacity constraints, then this system has been applied as a solution in which all transfers are transferred at a price i.e. marginal cost plus fixed fee that is being charged by the supplying division. This system is also known as two part transfer pricing system.
International Transfer Pricing:
Importance of transfer pricing at the international level cannot be neglected. The world has become a global village in the 21st century. So different countries transfer goods and services to the other respective countries, so in order to make this trade possible in good conditions, managers must have to use different transfer pricing method that suits both the parties. In this case many different problems like uneasy weather conditions, exchange rates may arise which can be overcome by using their respective techniques.
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