What is Transfer Pricing
Sometimes, a division will sell goods or services to another division within the same business. For example, a brick-manufacturing division may sell its products to a housebuilding division. The price at which transfers between divisions are made can be an important issue. Setting prices for inter-divisional trading is known as transfer pricing. For the division providing the goods or service, transfers represent part, or possibly all, of its output. If the performance of the division is to be measured in a meaningful way, the division should be credited with ‘sales revenue’ for these goods or services transferred. Failure to do so would mean that it would have to bear the expenses of creating the goods or service, but would receive no credit for doing so. By the same token, the receiving (buying) division needs to be charged with the expense of using the goods or service supplied by the other division, if its performance is to be measured in any meaningful way.
Where inter-divisional transfers represent a large part of the total sales or purchases of a division, transfer pricing is a very important issue. Small changes in the transfer price of goods or services can result in large changes in profits for the division concerned. As divisional managers are often assessed (and partially remunerated) according to the profits generated by their division, setting transfer prices may be a sensitive issue between divisional managers.
Whilst the particular transfer prices used will affect the profits of individual divisions, the profits of the business as a whole should not be directly affected. An increase in the transfer price of goods or services will lead to an increase in the profits of the selling division, which is normally cancelled out by the decrease in profits of the buying division. However, the transfer prices set between divisions can indirectly lead to a loss of profits to the business as a whole. This is because the level at which they are set may encourage a divisional manager to take actions that would benefit the division but not the business as a whole. For example a divisional manager may choose to buy a particular product or service from an external supplier because it is cheaper than the established internal transfer price. In such a situation, the profits of the business as a whole may be adversely affected.