Accounts Notes: Transfer Pricing

Tuesday 12 April 2011

Transfer Pricing

A transfer price is the amount of money that one unit of an organisation charges for goods and services to another unit of an organisation.

One of the key aspects here is that a transfer price is equivalent to an ordinary selling price and that any department or division that sets a transfer price is effectively selling its goods and services at a profit or a loss to another department or division within its organisation. Any part of an organisation using transfer pricing will be classed as a profit centre: since it is operating with a view to making a profit (whether positive, profit, or negative, loss). If goods and services are transferred between departments and divisions at cost, then no profit or loss arises and the issue of transfer pricing does not, or should not, arise.

Organisations have a system of transfer pricing, therefore, in order to assess the efficiency and effectiveness of its department and divisional managers. This maybe in spite of the fact that transfer prices may be artificial in the sense that it is felt that there is no rationale for “selling” between departments and divisions.

Criteria for fixing Transfer Pricing:-

i) External Capacity not fully utilized = Variable Cost

ii) Capacity fully Utilized
a) If single product :-
Selling Price (–) Selling Expenses

b) If multiple product
Variable cost + Opportunity cost (measured on the basis of Product actually sacrificed)

iii) If no market for Intermediate product
Cost of supplying division of optimum level
(-) Cost of the supplying division at previous output level.
Difference in Output

(This would be equal to Variable cost when Fixed Cost is same at all levels)

Note:-

i) Ignore Variable Selling expenses on Inter Department Transfer
ii) In case of (ii) above If selling expenses is not given we have to assume some % as selling Expenses but it should not exceed 5% .