When we set internal prices within inter-divisional trading of the organization, we consider that practice as transfer pricing. The objectives are to allow division manager to set goods and service pricing, to contribute inter-divisional sales which supports divisional revenue margin. To have a sustainable profits among divisions and to identify the level of goods and service output among divisions, and to reduce taxes when the company is operating in different countries. ‘When examining the various approaches, the extent to which they reflect the opportunity cost of the goods and service should be the appropriate benchmark against which they are measured.’(Atrill, P. & McLaney, E. 2012:412) According to Atrill, P. & McLaney, E. (2012:412) there are four different approaches, which include market prices, variable cost, full cost, and negotiated prices which needs to consider setting transfer pricing.
Market prices approach has to consider after determining of external market for the purpose of adopting company’s internal selling price of goods and service. The Market prices approach may not be appropriate depending on the times factors while the divisions are involved in the transfer pricing. For example, Colorland Pvt Ltd, has a production division that produce paints, the paints are sold to paint market buyers for each liter for $10. The production division is currently producing 500 liters a day, and the same division production capacity is 1000 liters per day, and the total cost per liter is $6. In the same organization, buying division has offered to buy 400 liters a day with a buying price of $5 a liter. In this case the buying division has an option to buy from the outside, and the same time selling division is operating below the capacity and needs to set the price for the market which result loss of revenue.
The variable cost approach is useful to the selling division if they produce less than the capacity in their manufacturing operation and sets the transfer price in a way that they can make some amount to the profit margin. To contribute profit margin, it is necessary the selling division to sets the transfer price above the variable cost of the goods and service. But there is no benefit for the selling division if they are producing at full capacity while their external market is ready to pay more than the variable cost.
Full cost approach can be applied but the selling division cannot make profit on this approach by setting transfer pricing at full cost. In this case top management needs to do performance evaluation within the divisions. Therefore this approach is not attractive for the selling or buying division. The reason is if the selling division have not included markup, they may lose on making profit margin. In the same time including markup become a problem if the buying division is already taking into account part of the overhead sharing policy among divisions.
When the transfer price is negotiated between selling division and the buying division that can be considered as the negotiated prices approach. If the division managers are providing information of the external market price, negotiation could be facilitated to advices to benchmark transfer price according to the market price. This is the best approach to minimize the conflicts between the division managers and both internal external stakeholders of the company.
In the global business environment, setting transfer pricing is not an easy task, it is always depending on organizational needs at different times. When we reconcile the different approaches, transfer pricing considered on full cost, ‘this preserves the selling division’s opportunity to make profit and rationalizes any overhead sharing by the buying decision.’(Warren, M. 2012:01) The other approach would be to keep two divisions with same standard of transfer pricing. In this case the division managers can do their business independently within the boundary specified by the company policy.