Transfer pricing comes into use when various divisions of a company deal with one another. A transfer price is that notional value at which goods and services are to be transferred by the supply division to receiving division. The goods that are produced by the buying division and sold to the outside world are known as final products. The department that supplies the goods is called Supply Division. The department that receives the goods is called Receiving Division. Transfer price becomes revenue for Supply Division and cost for Receiving Division.
General rule is that:
TRANSFER PRICE = VARIABLE COST + CONTRIBUTION LOST
Goods and services, which are the output of one division, would be transferred to another division as inputs. Transfer price becomes cost to the unit receiving the goods/ services and revenue to the unit providing the goods/services. Thus the profitability of the two units involved would be dependent upon the transfer price.
Fixation of transfer price are to be in such a manner that the overall profit of the company should not be reduced. It can be said the problem of suitable transfer prices arise only when divisions do business with one another.
Ideally the transfer price should motivate internal transfers rather than buying from outside. It should always be based on the outlay costs of supplying division plus an opportunity cost to the organization as a whole.
There are three bases available for determining transfer price, but many option are also available within each base. These methods are:
1. Market based prices: Under this method the transfer price are based on market prices.
2. Cost based prices:
a. Variable Cost: Under this approach, only variable cost is recovered. It is useful when the selling division is operating below capacity.
b. Actual full cost: In this method, price is based on the total cost per unit i.e. direct material, labour and factory overhead.
c. Full cost plus profit: The ‘full cost plus’ price is include the allowed cost of item plus a markup or other profit allowance.
d. Standard cost: Under this method transfer price will be fixed, based on standard cost which is predetermined scientifically.
e. Opportunity cost: Minimum and maximum prices correspond to the opportunity costs of transferring internally.
3. Negotiated Prices: Under this method both the division will negotiate for determination of transfer prices.
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