Transfer Pricing: Definition and Disadvantages!
A transfer price is that notional value at which goods and services are transferred between divisions in a decentralised organisation. In divisionalised companies, where profit or investment centres are created, there is likely to be interdivisional transfers of goods, or services and this internal transfers create the problem of transfer pricing.
In such companies, a satisfactory system of transfer pricing is necessary for measuring the performance of divisions. Transfer prices are normally set for intermediate products which are goods and services that are supplied by the selling division to the buying division. The goods that are produced by the buying division and sold to the outside world are known as final products.
It can be said that the problem of suitable transfer prices arises only when divisions do business with one another. One way to eliminate the need to establish transfer prices is to eliminate all transactions among divisions. The problem with this solution is that it would forgo for the company and the divisions the very substantial scale economies that come as a result of being able to centralise certain corporate functions while simultaneously achieving the benefits of decentralisation. On the other hand, the greater the number of transfer relative to the volume of a division’s operations, the less independent it becomes and the more meaningless it is to establish separate divisions with profit and investment responsibilities.
There are some disadvantages to be given due consideration before setting transfer prices. These disadvantages are:
(1) There can be disagreement among organisational divisional managers as to how the transfer price should be set.
(2) Additional costs, time and manpower will be required to execute transfer prices and design the accounting system.
(3) For some departments or divisions, for example service departments, transfer prices do not work equally well because these departments do not provide measurable benefits.
(4) Transfer prices may cause dysfunctional behaviour among managers of organisational units.
(5) The issue of transfer prices in multinational companies is highly complicated.
Besides the above, each type of transfer prices have their own merits and demerits.