Transfer pricing is a popular topic in management accounting. It is concerned with the price when one department (the selling department) provides goods or services to another department (the buying department). That is, one department generates revenue from the sales of goods or services and the other department incurs expenses from the purchases of goods or services. Transfer pricing is closely related to responsibility accounting in which each department is responsible for its cost, revenue, expense or investment return depending on the type of centre it is. Thus, transfer pricing effectiveness is essential to the success of the overall company. The related key issue is the determination of a transfer …show more content…
Also, there are no additional costs or benefits from buying or selling to the external market instead of selling the items internally.
In such a situation the company as a whole has no additional cost of providing autonomy to divisions. For example, if division A decides to sell its product at the market price of Rs. 100 per unit and division B decides to buy the same product from market at the market price, net cash flow to the firm will be zero.
If the market for the intermediate product is imperfect, this system may lead to sub-optimal utilisation of production capacity by the buying division. The transfer price will form an element of the total marginal cost and the buying division will restrict its output at the level where marginal cost = marginal revenue. Thus the firm as a whole will lose an opportunity to improve its profit because actual marginal cost is lower than the transfer price.
For instance, the intermediate product that the sub-unit A of the firm uses is produced by the sub-unit B of the firm and another firm. The market price of the product is Rs 100 per unit, while the variable cost of production in division B is Rs 40 per unit. If, the transfer price is fixed at Rs 100 per unit (the market price) the sub-unit A will consider Rs 100 per unit as a part of its