Transfer pricing represents the price paid from one company to another for a product or service when both are owned and report to the same parent company. Transfer pricing policy dictates the approach taken by the two companies when determining the price for the product or service. Companies incorporate different transfer pricing policies to achieve different objectives.
External Market Price
Some companies employ a transfer pricing policy that incorporates the external market price for all inter-company transactions. The shipping facility charges the receiving facility the same price it charges customers outside of the organization. If the receiving company is able to obtain the same product or service at a cheaper price outside of the organization, it is encouraged to do so. The advantage of this policy is that all transactions occur at the higher market price, allowing the company to maximize profits. The disadvantage of this policy is that the company loses control over quality when purchasing from outside the company.
Contribution Margin Approach
Companies who encourage a contribution margin approach to their transfer pricing policy split the contribution margin of the final product with all contributing facilities. When the company sells the final product to a customer, the company determines the contribution margin percentage of that product. Each contributing facility determines the cost of the component and applies the same contribution margin percentage to that component. The cost plus the contribution margin equals the transfer price of the component. The advantage of this policy is that the contribution margin is shared equally among all facilities. The disadvantage is that the transfer price may not be known until the product is eventually sold to the final customer.
Companies who incorporate a transfer pricing policy using a cost-plus approach provide for shipping facilities to recoup the costs and an additional amount to contribute to that site’s profits. The shipping facility calculates its costs and adds a predetermined percentage to that cost. The advantage of this policy is that the calculation is simple to do. The disadvantage is that the shipping facility has no incentive to manage its costs.
Negotiated Transfer Price
Using a negotiated transfer pricing policy gives each facility some latitude in determining the price to use for inter-company transfers. The shipping facility determines the lowest price by calculating its product cost. The receiving facility determines the highest price by researching what it can pay for a similar product outside of the company. Managers from the two companies meet and negotiate a price in the middle. The advantage of this policy is that both companies feel ownership over the pricing decision. The disadvantage is that the control lies with the two managers, not with the parent company.