Transfer Pricing
Often, the output of one division can be used as input for another division. For example, integrated circuits produced by one division can be used by a second division to make video recorders. Transfer prices are the prices charged for goods produced by one division and transferred to another. The price charged affects the revenues of the transferring division and the costs of the receiving division. As a result, the profitability, return on investment, and managerial performance evaluation of both divisions are affected.
The Impact of Transfer Pricing on Income
Exhibit 10-2 illustrates the effect of the transfer price on two divisions of ABC, Inc. Division A produces a component and sells it to another division of the same company, Division C. The $30 transfer price is revenue to Division A and increases division income; clearly, Division A wants the price to be as high as possible. Conversely, the $30 transfer price is cost to Division C and decreases division income, just like the cost of any materials. Division C prefers a lower transfer price. For the company as a whole, A’s revenue minus C’s cost equals zero.
Often, the output of one division can be used as input for another division. For example, integrated circuits produced by one division can be used by a second division to make video recorders. Transfer prices are the prices charged for goods produced by one division and transferred to another. The price charged affects the revenues of the transferring division and the costs of the receiving division. As a result, the profitability, return on investment, and managerial performance evaluation of both divisions are affected.
The Impact of Transfer Pricing on Income
Exhibit 10-2 illustrates the effect of the transfer price on two divisions of ABC, Inc. Division A produces a component and sells it to another division of the same company, Division C. The $30 transfer price is revenue to Division A and increases division income; clearly, Division A wants the price to be as high as possible. Conversely, the $30 transfer price is cost to Division C and decreases division income, just like the cost of any materials. Division C prefers a lower transfer price. For the company as a whole, A’s revenue minus C’s cost equals zero.
While the actual transfer price nets out for the company as a whole, transfer pricing can affect the level of profits earned by the company as a whole if it affects divisional behavior. Divisions, acting independently, may set transfer prices that maximize divisional profits but adversely affect firmwide profits. For example, suppose that Division A in Exhibit 10-2 sets a transfer price of $30 for a component that costs $24 to produce. If Division C can obtain the component from an outside supplier for $28, it will refuse to buy from Division A. Division C will realize a savings of $2 per component ($30 internal transfer price - $28 external price). However, assuming that Division A cannot replace the internal sales with external sales, the company as a whole will be worse off by $4 per component ($28 external cost - $24 internal cost). This outcome would increase the total cost to the firm as a whole. Thus, how transfer prices are set can be critical for profits of the business as a whole.Read setting transfer prices
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