Different Types of Transfer Pricing Methods

Different Types of Transfer Pricing Methods

There are different types of transfer pricing methods. Discussing each and every method is beyond the scope of this report. We will discuss only three main transfer pricing methods. There is not a single transfer pricing method which could be applied universally. Each method is best suited in different situation and each method has certain limitations. I have discussed about the best suited situation and limitations of each method one by one.

Market based transfer pricing

Market based transfer pricing method is best suited for those organizations which are operating in perfect market where products are homogeneous and there is one price both for the sellers and the buyers with no additional costs of buying or selling. In perfect market, the selling division will be operating at the full capacity and it will be able to sell each and every unit produced in the external markets. In these circumstances, if one division have to transfer a product to another division then the selling division will have to sacrifice the external market selling price. In this situation, if the product is not transferred at the market price to other department then the organization will have to bear opportunity cost. 

In this case the transfer price should be:

Transfer Price = Manufacturing cost + Operating Cost = Market Price

The transfer price and the market price will be equal in perfect market, therefore, both divisions; the selling division as well as the buying division will be satisfied. Criteria of efficient and effective transfer price can be meet by adopting market based transfer pricing method in perfect market as the organization will be able to evaluate the performance on equitable basis, divisional autonomy will be preserved, and goal of congruent decision making will be promoted. 

Other than the benefits of market based transfer pricing method mentioned above, there are certain limitations of market based transferring method like; if product differentiation exists in the external market then the organization will not be able to compare the product and compare the market price, in this way a satisfactory price will not be set and the both departments will be unsatisfied. If, an organization is operating in imperfect market then there will be lots of price variation due to under supply or over supply or due to the dumping of product by the foreign competitors, again, there will be hurdles in setting a suitable transfer price which will result in creation of conflicts between the departments and the organization will not be able to measure the performance of divisions on fair basis. 

Full Cost based transfer pricing

Mostly, the organizations operate in imperfect markets. So, it will be really an unwise decision from an organization if it adopts variable cost based transfer pricing method. In other words, it will be unwise decision if the organization set transfer price on the bases of variable costs as they vary with the passage of time and these don't cover the costs of fixed assets which are used in production process. If an organization adopts cost based transfer pricing method then in this situation the selling division will want to transfer the goods at absorbed costs in order to cover the costs of overhead due to usage of fixed assets. (Zimmerman 2011)Full cost based transfer pricing method is widely popular in managers as this method helps the managers in evaluating the marginal cost in long run which is necessary for the managers for their decision making process. However, the traditional method of absorbed costing provides poor estimates about the marginal cost which is important for decision making. The cost based pricing method has a big limitation that it provides opportunity to commit "Sub-optimal" decision making because the buying department have to regard the whole transfer price as variable cost which actually contains the fixed prices as well, in this way, the organization is not able to generate a true picture of its business operations. 

Negotiated Transfer Pricing

As mentioned previously that the mostly the organization operate in imperfect market where different products with different prices exists. In this, way, it is not a good decision to set the transfer price at an optimal or planned market price as in the market there are different products with different prices and the selling and the buying departments can't follow an optimal output level due to the variation in demand of the products. In these circumstances, it is better for the corporate or the central management to intervene and set a transfer price but this step will halt the autonomy of divisions which could ultimately demotivate the divisional managers. To resolve or reduce the impact of this issue, it is more suitable to adopt negotiated transfer pricing method. To successfully implement or to fully utilize the benefits of negotiated transfer pricing method, it is necessary that both the managers are well informed and have been educated to correctly use the information. If the managers are well informed and have been educated to correctly use the information then the managers will be able to reach to a negotiated price which will be acceptable and beneficial for the both departments as well as for the company. 

Other than the above, there are certain limitations of the negotiated transfer pricing methods like; sub-optimal decision making, negotiated transfer pricing methods is time consuming because the managers require time to negotiate which is not beneficial for the departments as well as for the overall organizational performance. 

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    Dreu - 4/17/2017 3:31:50 AM

    I think that it is interesting to add that the theories mentioned are part of the general theory of determining market (transfer) prices. Because the term "Transfer pricing methods" is nowadays most often used to refer to the methods that multinationals are required to use for their inter-company transactions to prevent aggressive tax planning. For example, management fees or administration services that a head office charges to a regional office, have to be comparable to the prices of independent enterprises. This is called an "arm's length" price. There are 5 of these transfer pricing methods used around the world, based on a working paper of the OECD. With these methods, you look either at "transactions" or "profit" of comparable transactions to determine the correct transfer price.


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