Transfer Pricing Meaning
A small company sells its products only to outside customers but as far as big company is concerned such companies not only sells its products to outside customers but it also supplies goods within the company to other divisions according to their requirement and in order to account for such transfer within divisions company uses transfer pricing method as transfer price is always lower than normal selling price of the company. Transfer pricing in simple words refers to that price at which divisions or departments within the company transfer products or resources with each other, in order to understand this concept better one should look at advantages and disadvantages of transfer pricing –
Advantages of Transfer Pricing
Cost saving for Departments
It results in cost savings as far departments are concerned because transfer price is usually lower than the market price of the product, hence for example if the multinational company produces batteries as well as mobiles than mobile division can purchase batteries from battery division of the company resulting in cost savings for mobile division of the company.
Transparency
It makes dealings between various departments transparent because in the absence of transfer price mechanism departmental heads will charge price arbitrarily resulting in them exploiting the department who is in need of the product and thus creating animosity between departments which in the long term can cause irreversible damage to the company.
Readily Available
Another advantage of this mechanism is that since goods are manufactured in the company itself as far as other departments are concerned they do not have to depend on suppliers as goods are readily available in the company itself which saves the company from the exploitation of the suppliers of the goods.
Disadvantages of Transfer Pricing
Complicated Process
The biggest disadvantage of transfer price is that it is a complicated process as unlike market price which is determined by the demand and supply of the good transfer price is not decided by market forces alone rather many other variables come into play which makes this process complicated as well as questionable.
Animosity between Departments
It can create an unnecessary rift between the departments because departments which supply goods to other departments will feel that they are sacrificing their profit by not selling their products to the market as market rates are higher than transfer price. In simple words suppose you own a home and due to some reason for 6 months you have to give that home on rent to your relative or friend then you will be taking less rent than market rent, the mechanism of transfer price is somewhat similar and hence can cause anger as well as frustration in the company.
Sub Standard Products
If a company follows a transfer pricing strategy than it forces the departments to buy products from within the company even if those products are of inferior quality which in turn make products of other departments also inefficient. In simple words it compels the department heads to buy products from other departments of the company even when there are better substitutes for the product is available in the market.
As one can see from that deciding transfer price puts the company in a tricky position and that is the reason why a company should first read above pros and cons and then formulate the transfer pricing so that all departments or divisions of the company remains happy as well as motivated for contributing to the success of the company.