Transfer Pricing

Robert Baxter

Individual Research Paper

Transfer Pricing

4-30-2013

The "transfer price" is the value or amount recorded in the firm's accounting records when one business unit sells (transfers) a good or service to another business unit" (Lanen, Anderson, & Maher, 2011, p. 549). The purpose of this paper is to give the reader an overview of transfer pricing. In this paper several different methods of transfer pricing will be discussed, as well as problems with the system.

Market-based, negotiated, and cost-based pricing are used to establish the prices for the transfer policies. "Externally based market prices are generally considered the best basis for transfer pricing when a competitive market exists for the product and market prices are readily available." (Lanen, Anderson, & Maher, 2011, p. 559) Using this policy ensures that the buyer and seller are apathetic and have no ulterior motive in their decisions to sell internally or externally. According to (Caplan, 2010) "...managers strive to maximize divisional profits, a market-based transfer price aligns their incentives with owners' incentives of maximizing overall corporate profits." Market prices are a good way for firms to make sure that the firm is always kept at the forefront of each transaction. It is the firm who in the end will suffer the consequences from a slip in pricing based off the management's decision.

Next is the method of negotiated pricing, this term means exactly what it sounds like. The firm does not create specified rules for setting the transfer price it is left up to the managers to negotiate with each other a fair and agreeable price. When this method is used the managers are kept in the loop so to speak. Giving them the power to negotiate the pricing is a good way to build employee morale. This in turn can give them the initiative to try and do what is best for the company, because their choice carries the weight of the company on it.

This method does have its disadvantages as well "...management effort can be consumed in the negotiating process and that the final price and its implications for performance measurement could depend more on the manager's ability to negotiate than on what is best for the company" (Lanen, Anderson, & Maher, 2011, p. 562).

Last is cost-based pricing this method has several different variations to it. The first one is full absorption cost-based, when this particular variation is used the cost base is calculated by using both the total direct costs and overhead costs from the manufacturing of a particular product. Then comes cost-plus transfers this is "transfer pricing policy based on a measure of cost (full or variable costing, actual or