When goods or services are transferred within an organization there needs to be a way of tracking this for accounting purposes. Transfer pricing is a method by which resources can be transferred between different divisions or subdivisions of an organization. This transfer price can also apply to any subsidiaries of the business. The purpose of doing this is to optimize the performance of the organization as a whole and to determine how each division of the company is performing. It makes it possible to calculate each division’s profits and losses separately.
There is a lot of interest in transfer pricing and it can sometimes come under scrutiny. This is particular true in regards to how this is done within a multinational company. By changing the price of these resources there will be an influence on the profitability of that division. This could lead to a situation where some divisions have it harder than others. There is also the worry that it can be used as a method to escape taxes.
How Does Transfer Pricing Work?
The price for transferring resources within a company can vary. The usual guiding principle is that the amount should be similar to what a normal customer would pay for the resource. Some businesses may choose to use the original purchase price when transferring. Alternatively they could decide to use a lower price which takes into account depreciation in the value of the resource. If the business has divisions spread out around the world they may also include a shipping cost as part of the transfer price.
The Benefits of Transfer Pricing
There are a number of potential benefits to be had by using this method for transferring resources within an organization including:
- It encourages each division of a business to optimize their performance and this improves the overall performance of the organization.
- It gives each division the information they need to make the most appropriate decisions.
- It makes it possible to evaluate the performance of each section of the company
- It avoids the need for lots of postings on the accounts payable and accounts receivable books thus making accounting easier to handle.
Criticisms of Transfer Pricing
There are criticisms that this type of movement of resources is open for abuse. This is particularly true when it comes to international companies and there is the fear that it can be used as a means to evade taxes. This type of abuse is now monitored for carefully and many countries will come down hard to prevent it from occurring. It is now usual for countries around the world to have rules governing the transfer of resources within multinationals in their jurisdiction.
Another fear with this type of system is that transfer pricing may distort a division’s performance if the prices are incorrect. This could mean that a division that isn’t performing well benefits from a division that is performing well. There is also the worry that this artificial pricing can reduce the earnings of minority share holders.