Transfer pricing is the set of mechanisms which is used to attach prices to goods or services which are traded between two divisions of the same company. The classic example involves one division (the “selling division”, or “SD”) which produces a component which is required by another division (the “buying division”, or “BD”). The component is used by the BD in the manufacture of a product which it sells on the open market.
In case all of this sounds a bit abstract, let’s consider a simple example of a company in which the SD manufactures car engines and the BD manufactures cars. A couple of things are obvious:
1. The BD needs the output of the SD, because the BD needs car engines in order to make cars. Alternatively, the BD may be able to buy engines from an external supplier if, for example, the BD and SD cannot agree on a transfer price for the engines.
2. The SD can sell its output either to the BD or to external customers (in this case, these external customers would be other car manufacturers, many of which would be only too happy to buy in a ready-made engine).
The transfer price represents a source of revenue to the SD, and a cost to the BD. Therefore, there is potential for inter-divisional conflict (or at least a need for inter-divisional negotiations) since the SD will want to maximize the transfer price while the BD will want to minimize it.
When we are preparing the Profit and Loss Account of the company as a whole, the transfer price is neither a cost nor a revenue. The transfer price is not taken into account in the calculation of company profit, since it is simply the price attaching to an intra-company transaction.
It is therefore reasonable to ask whether, from the company’s point of view, it really matters what level the transfer price is set at. The answer is that it matters a great deal. If the “wrong” transfer price is set, then this