A transfer price may be defined as price related to goods or other services transferred from one sub unit (process, department, member of the group, etc) to another sub unit within the same organization.
The following are the purpose of transfer pricing:
- Goal congruence; this is achieved by providing information that motivates divisional managers to make good economic decisions and take actions that will improve both profits of their divisions and organization as a whole
- They serve as a guide to local decision-making
- Moving profit between division or locations; transfer pricing may be used for the purpose of shifting profit from one division to another or to headquarter, this will be influenced by many reasons such as a tax rate, custom duties etc.
- To ensure that division autonomy is not undermined; transfer pricing make divisional managers operate independently and thus not undermine their autonomy
- Tax minimization; where the business has operations in various countries , it may be beneficial to set transfer prices such as the bulk of profit are reported in the division where the host country has low corporation tax rates. However, the laws operating in many countries will seek to prevent this kind of profit manipulation.
- Promoting the optimization of profit for the business; transfer price may seek to optimize profits for the business as whole. For the example, a division may be prevented from quoting transfer price for goods that will make buying division to seek cheaper sources of supply from outside the business
- Allocating divisional resources; transfer rices are important in determining the level of output for particular goods and services. The level of return from inter divisional sales can be important in deciding the level sales and investment relating to a particular product or group of product
- Performance evaluation. they enable the use of profit as a measure of sub unit performance