9.8 Transfer Pricing

Transfer prices

Profit centers and investment centers inside companies often exchange products with each other. The Pontiac, Buick, and other divisions of General Motors buy and sell automobile parts from each other, for example. No market exchange takes place, so the company sets transfer prices that represent revenue to the selling division and costs to the buying division.

A transfer price is an artificial price used when goods or services are transferred from one segment to another segment within the same company. Accountants record the transfer price as a revenue of the producing segment and as a cost, or expense, of the receiving segment. Usually no cash actually changes hands between the segments. Instead, the transfer price is an internal accounting transaction.

Segments are generally evaluated based on some measure of profitability. The transfer price is important because it affects the profitability of the buying and selling segments. The higher the transfer price, the better for the seller. The lower the transfer price, the better for the buyer.

Ideally, a transfer price provides incentives for segment managers to make decisions not only in their best interests but also in the interests of the entire company. For example, if the selling segment can sell everything it produces for $100 per unit, the buying segment should pay the market price of $100 per unit. A seller with excess capacity, however, should be willing to transfer a product to the buying segment for any price at or above the differential cost of producing and transferring the product to the buying segment (typically all variable costs).

In practice, companies mostly base transfer prices on (1) the market price of the product, (2) the cost of the product, or (3) some amount negotiated by the buying and selling segment managers.

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