What is Transfer Price?
An organization with different profit centers and investment centers may have inter-trading between different centers. Some profit centers will supply goods and services to others. The prices at which transaction is made is called transfer price.
How it Works (Example)
If division A provides goods for $ 100 to division B. Individually, The sale income of division A will be offset by purchase cost of division B. Because both divisions are part of a single organization as a whole.
How should it Work
- Both divisions must benefit from the inter-trading
- Transfer prices must be established by head office or commercial negotiation between divisional managers.
- Preference should be given to purchasing or sell internally. However, on the basis of good commercial reason, a division should be allowed to sell externally rather than transfer internally and vice versa.
- Good commercial reason means, An external customer offering high price or external supplier offering a low price.
Why it Matters
Transfer pricing system is used to
- Fairly allocation of profit between divisions.
- Recording the movement of goods between divisions.
- Reasonable measure of managerial performance by analyzing divisional profit reports.
- Multinational companies move profit around the world to minimize the global tax liability.