Transfer pricing is the setting of the price for goods and services sold between controlled or related legal entities within an enterprise. For example if the subsidiary company sells goods to the parent company the cost of those goods paid by the parent to the subsidiary is the transfer price.
Bases for determining transfer price are as follows:
Cost based transfer price,
This method offers the choice of various options as the bases for deciding the transfer price. These options are
- Variable/marginal cost; under this method , units are transferred at variable costs incurred for those units. Fixed cost is borne by transferor department;
- Full cost; under this method the total cost incurred for the units is considered when deciding the transfer price. This cost include both the fixed cost and variable costs of the product;
- Cost plus method; here, in this method, the markup is added to the cost to cover the profit share of the transferor department/division. As the result, although the profitability of the transferee division increases, the overall profitability of the organization as whole remain the same.
Market based method
Here, the listed price of the product is considered when determining the transfer price. This method is often considered to be the most suitable method. One disadvantage of this method is that, for most of intermediate product the external market is not available and it is therefore difficult to determine their market price.
Negotiated transfer price
In this method, the transferee and transferor divisions negotiate and then arrive at price acceptable to both divisions. In most cases, the market price is taken as the basis of determining the negotiated transfer price. Under this method, a division with poor bargaining skills loses out to one with superior bargaining skills