Market value

There is universal agreement that in competitive markets a market value based transfer price should achieve optimal results. In this circumstance, it can be expected that:

1) The autonomy of the division is not undermined because markets determine the value of outputs, not centralized departments or divisional costs. Market prices would be seen to be objective and fair to all. The aim of creating an organizational structure where each division operates as an organization in its own right can be achieved. Ideally, suppliers should be permitted to sell to external customers and receivers should be allowed to buy from external producers.

2) Managers' performance reflects their ability to compete with external companies in a free market. This may be a fair indication of the manager's ability and potential to perform at higher levels within the organization and thus forms a fair basis for promotion and salary decisions;

3) From 2, it can be expected that the transfer pricing mechanism will be neutral in motivating managers to perform in accordance with organizational goals; that is, the transfer pricing mechanism will not be biased in any manner other than that created by market forces. Performance measurement schemes can thus be established to motivate managers to act in a goal congruent manner;

4) Reliable decisions would arise at divisional level. For instance, in a joint product situation, products, which should be sold at the split-off point would not be processed further since the post split-off processing division would show a loss based on the transfer price.

Unfortunately, two problems illustrate that market based prices may not be able to achieve these aims in all circumstances. The first problem arises because transfer pricing situations are not simply selling situations. The supplying division, for instance, does not have to incur the costs of selling normally associated with selling to external customers. The receiving division may be in a position to influence quality and delivery because it is in the interests of both divisions that the company as a whole prospers. It is sometimes desirable to adjust the market price to reflect such factors, with a commensurate loss in the objectivity which market prices can bring. The second problem is more fundamental; there may simply not be a perfect market in operation. A vertically integrated company, for instance, may not possess a market for its intermediary products. In this case, there is no market from which to establish market values. Other market imperfections would produce bias which would work to the benefit of either the supplying or the receiving division.