Transfer Pricing--Market-Based vs. Cost-Based

2656 Words May 13th, 2008 11 Pages
Introduction
Transfer pricing is one of the key factors of a management control system, which helps a company to achieve its goals, including profit maximization and tax minimization.
There are several methods of setting transfer prices among profit centers within the same organization. Each profit center tries to set transfer prices which maximize their own profit. The buying and selling profit centers’ profits are largely affected by transfer prices. For example, when a high transfer price is charged, the selling division’s profits increase, while the buying division’s costs increase. So, transfer pricing should be established on a reasonable and objective basis, which should maximize the companywide profit, rather than being based on
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The company should consider whether the transfer pricing method has simplicity and transparency, which provide objective performance measurements for division managers. With regard to simplicity and transparency, it is best for the company to set market-based transfer pricing because this is more objective than cost-based transfer pricing. In particular, when companies use cost-based transfer pricing, it is difficult to evaluate division performance unless the transfer prices exceed full costs.
Generally, a company can save more money and effort through internal sales compared with external sales, due to the absence of customer credit checking or collecting. In addition, market-based transfer prices contribute to the evaluation of the economic viability and profitability of profit centers individually. Market-based transfer pricing portrays the real market supply and demand more clearly because, when supply exceeds demand, market prices may decrease, so market-based transfer prices decrease as well.
However, market-based transfer pricing has several disadvantages. You cannot use the market-based transfer pricing method when there is no market price in the market. For example, when the selling division makes specially customized products for the buying division, you cannot get a market price for the products. Similarly, in the case of a pharmaceutical company selling patent-protected drugs, you cannot get an appropriate market price for
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