Transfer Pricing

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Description of Transfer Pricing. Explanation.


Definition Transfer Pricing. Description.

Transfer Pricing (TP) refers to the process and practice of pricing exchanges of goods and services amongst divisions of large multi-divisional organizations.

Usage and Manipulation of Transfer Prices

Transfer prices are used and also misused for a number of reasons:

  1. Obviously, TP should be used in an attempt to allocate profits and losses for each division in such a way that the corporate strategy of the overall corporation is supported in the optimal way.
  2. TP can be a contentious political issue in corporations and especially amongst senior level executives. This is because the level at which transfer prices are set may negatively influence their division profits and as a result cause lower bonuses to accrue to the managers.
  3. Transfer Pricing can be manipulated for taxation reasons: by charging low transfer prices from a unit based in a high-tax country that is selling to a unit in a low-tax country, a firm can record a low profit in the first country and a high profit in the second.

Observable Transfer Prices and Unobservable Transfer Prices

In an article, Gox examined when to choose transfer pricing, focusing on divisionalized companies dealing with duopolistic price competition (Gox, R. F., “Strategic Transfer Pricing, Absorption Costing, and Observability”. Management Accounting Research, 2000, Vol. 11, p. 327-348).
According to the article, one has to distinguish between observable transfer prices and unobservable ones:

  • In the first case it is better to charge a price above the marginal costs of the intermediate products. In this way managers of the firm are committed to act as a softer competitor on the final product market. Because both firms intend to increase their prices strategically, there does an equilibrium price above the marginal costs of the intermediate product. Transfer pricing is a profitable choice in this case since these will be higher than profits attainable under marginal-cost based transfer pricing.
  • However, when transfer prices are not observable there will not be an equilibrium with strategic transfer pricing used in the observable case. In the unobservable case it is optimal to use a transfer price equal to the marginal costs of the intermediate product. In this case neither of the two divisionalized companies is able to manipulate the strategic equilibrium of the other company’s managers and as a result deviating from marginal costs as the transfer price will only cause suboptimum price setting by the manager him/herself.

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