Transfer Pricing--Market-Based vs. Cost-Based
Introduction
Transfer pricing is one of the key factors of a management control system, which helps a company to achieve its goals, including profit maximization and tax minimization.
There are several methods of setting transfer prices among profit centers within the same organization. Each profit center tries to set transfer prices which maximize their own profit. The buying and selling profit centers’ profits are largely affected by transfer prices. For example, when a high transfer price is charged, the selling division’s profits increase, while the buying division’s costs increase. So, transfer pricing should be established on a reasonable and objective basis, which should maximize the companywide profit, rather than being based on an individual division’s profit. The company can choose market-based transfer pricing, cost-based transfer pricing, or negotiated transfer pricing.
We will mainly focus on comparing market-based transfer pricing and cost-based transfer pricing in order to evaluate which method is more appropriate in each case. We will also analyze an entity’s transfer pricing policy.
Market-Based Transfer Pricing
First of all, market-based transfer pricing tries to align the incentives of profit centers with the overall companywide goal. Market-based transfer pricing is ideal, and achieves congruence of the company’s goals, when the market is perfectly competitive. However, it is hard to have a perfectly competitive market.
Eccles (1985) argues that market-based transfer pricing is appropriate when diversification is high. This may result from the general manager’s ability to understand cost pools completely and apply them to transfer pricing. For example, in the case of a highly diversified firm, such as General Electronics, the general manager cannot completely understand the cost of each division. In that case, the general manager may set transfer prices based on market prices. Eccles also argues that the general manager should mandate
Transfer pricing is one of the key factors of a management control system, which helps a company to achieve its goals, including profit maximization and tax minimization.
There are several methods of setting transfer prices among profit centers within the same organization. Each profit center tries to set transfer prices which maximize their own profit. The buying and selling profit centers’ profits are largely affected by transfer prices. For example, when a high transfer price is charged, the selling division’s profits increase, while the buying division’s costs increase. So, transfer pricing should be established on a reasonable and objective basis, which should maximize the companywide profit, rather than being based on an individual division’s profit. The company can choose market-based transfer pricing, cost-based transfer pricing, or negotiated transfer pricing.
We will mainly focus on comparing market-based transfer pricing and cost-based transfer pricing in order to evaluate which method is more appropriate in each case. We will also analyze an entity’s transfer pricing policy.
Market-Based Transfer Pricing
First of all, market-based transfer pricing tries to align the incentives of profit centers with the overall companywide goal. Market-based transfer pricing is ideal, and achieves congruence of the company’s goals, when the market is perfectly competitive. However, it is hard to have a perfectly competitive market.
Eccles (1985) argues that market-based transfer pricing is appropriate when diversification is high. This may result from the general manager’s ability to understand cost pools completely and apply them to transfer pricing. For example, in the case of a highly diversified firm, such as General Electronics, the general manager cannot completely understand the cost of each division. In that case, the general manager may set transfer prices based on market prices. Eccles also argues that the general manager should mandate