Transfer Pricing--Market-Based Vs. Cost-Based

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 an individual division’s profit. The company can choose market-based transfer pricing, cost-based transfer pricing, or negotiated transfer pricing.

We will mainly focus on comparing market-based transfer pricing and cost-based transfer pricing in order to evaluate which method is more appropriate in each case. We will also analyze an entity’s transfer pricing policy.

Market-Based Transfer Pricing

First of all, market-based transfer pricing tries to align the incentives of profit centers with the overall companywide goal. Market-based transfer pricing is ideal, and achieves congruence of the company’s goals, when the market is perfectly competitive. However, it is hard to have a perfectly competitive market.

Eccles (1985) argues that market-based transfer pricing is appropriate when diversification is high. This may result from the general manager’s ability to understand cost pools completely and apply them to transfer pricing. For example, in the case of a highly diversified firm, such as General Electronics, the general manager cannot completely understand the cost of each division. In that case, the general manager may set transfer prices based on market prices. Eccles also argues that the general manager should mandate market-based transfer pricing when vertical integration is high, and exchange autonomy when vertical integration is low. In circumstances where a company values its autonomy highly, market-based transfer pricing is effective only when the buying division is willing to pay the market price for the selling division in the same company. The buying division can contribute to incremental profits for the company simply by purchasing the products from the selling division and either reselling them outside the company, or using the products in its own production process. So, the successful adoption of market-based transfer pricing depends on the cooperation of the buying division when the company considers autonomy as one of the key factors for success.

Emmanuel and Mehafdi (1994) argue that transfer pricing is determined by several factors, including strategy with respect to differentiation. Companies should choose market-based transfer prices when they choose a low-cost approach to develop a sustainable competitive advantage in the market. This is reasonable, because companies have to focus on reducing costs under a low-cost strategy. However, trying to minimize costs does not make transfer pricing more accurate. It rather tends to increase conflicts between divisions. Each division manager makes an effort to set a transfer price which is profitable for their own division. For example, when companies use cost-based transfer prices, the buying division would like to pay the standard cost for intermediate products, and the selling division would like to sell using the full-cost system. It is better for the companies to use a market-based transfer price to avoid the conflicts between profit centers.

The transfer pricing method is also affected by performance evaluation. Borkowski (1992) argues that the use of division profit for performance evaluation contributes to the transfer pricing method. When the company links performance evaluation with division profit, and divisional managers’ bonuses are largely dependent on division profit, the divisional managers aggressively make efforts to maximize divisional profit. 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 those products. In addition, the transfer price can fluctuate rapidly for some products, such as products with seasonal effects or economic effects. When companies are easily affected by those fluctuating market prices, it is better for them to use cost-based transfer pricing, or to set additional policies to protect profit centers from volatile price changes.

Cost-Based Transfer Pricing

As an alternative to market-based transfer pricing, the company can choose cost-based transfer pricing, as this can also promote goal congruence to some degree.

Eccles (1985) also argues that a company should accept cost-based transfer pricing when vertical integration is high and diversification is low. For example, in the case of a related diversified firm, such as Pelican Instruments, the general manager tends to understand more about the cost system compared with the general manager of a highly diversified firm. The general manager can accept more relevant cost-based transfer pricing, which reflects the costs of products clearly, when there is high vertical integration.

Furthermore, Colbert and Spicer (1995)