Transfer pricing is a method of determining prices for sales between divisions within a company. As previously discussed, the success of a profit center or investment center will be seen from the division's ability to generate profits. Division profits are obtained both from sales outside the company and sales between divisions within the company. Therefore, one of the uses of transfer pricing is to measure the performance of a responsibility center.
Determination of transfer pricing must meet three criterias, namely:
- Accurate performance appraisal, meaning that the price determined should not benefit one division yet harm another
- Goal congruence, meaning the determined price must be able to maximize the company's profits as a whole.
- Autonomy over divisional freedom in decision making, this means that each division involved in the transaction has the right to decide whether to accept or reject the offer without interference from the head office.
The best transfer price determination is to use the opportunity cost approach. In this approach, the transfer price can be divided into two parts, namely the minimum transfer price and the maximum transfer price. The minimum transfer price is always seen from the selling division’s point of view, where they establish the minimum transfer price that can be accepted so that transactions can be carried out. The formula for determining the minimum transfer price is variable costs added by opportunity costs. While the maximum transfer price will be seen from the buying division’s point of view, where they determine the maximum transfer price that can be accepted so that the transaction can be carried out. The amount of the maximum transfer price is usually the market price (the purchase price of the division from outside the company).
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