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for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately. cing
Goal Congruence
While designing the mechanism for transfer pricing, the interests of profit centers should neither supersede the interests of the overall organization, nor should there be a clash of interests between the organization and its profit centers. In other words, there should be goal congruency between profit centers and parent organization. Some of the prerequisites for achieving goal congruency are:
Transfer Pricing
Competent people Good organizational atmosphere Details of market prices Freedom to source Availability of information Scope for negotiation Competent people Organizations need managers who can balance long-term and short-term goals. Managers are often accused of sacrificing long-term gains for short term profits. This approach can prove disastrous for the organization. Transfer pricing can be misused for manipulating profits, and this gives a wrong picture of the position of the company. Hence, organizations should have competent people skilled at negotiation and arbitration, who are capable of determining the appropriate transfer prices. This makes goal congruency possible. Good atmosphere In order to achieve goal congruency, managers of profit centers, especially the buying profit centers, should ensure that the transfer prices charged by the selling profit centers are just. This will create an atmosphere of trust between selling profit center and buying profit centers.
Details of market prices When a product is transferred from one profit center to another, the normal market price for the identical product can be taken as the basis for establishing the transfer price. The market price should reflect the same conditions in terms of quantity, quality, time for delivery, etc. as characterize the product to which the transfer price applies. The market price can be adjusted to reflect savings due to lower expenses on advertising and marketing as the product is sold within the company. Freedom to source Managers of selling profit centers should be given freedom to sell their goods in the external market, while managers of buying profit centers should be allowed to buy their goods from the external market. Thus the market becomes the main determinant of the transfer price. Availability of information Managers should be fully aware of market conditions and should have all the necessary information available to them, before they take any decision. For example, managers should be aware of the alternatives available and the relevant costs of and revenues derivable from each alternative. Scope for negotiation There must be a mechanism for negotiating contracts, and managers who take transfer pricing decisions should be trained in negotiation. If all the above conditions are met, then companies can devise a mechanism for transfer pricing based on the market price. But quite often these conditions are not fulfilled, and it becomes difficult to achieve goal congruency. Some situations that are not favorable for achieving goal congruency are: Limited markets Excess or shortage of capacity in the industry Limited markets Markets for buying and selling the goods of the profit centers may be either very small or nonexistent. Some of the reasons for this are: Firstly, the profit center may have spare internal capacity, but may not wish to make any external sales. Secondly, if the company is the sole producer of a differentiated product then outside capacity does not exist. Thirdly, a company that has invested heavily in facilities will not want to source goods from outside unless the selling price in the market is as low as its own variable cost. Excess or shortage of industry capacity There may be situation of excess capacity or shortage of capacity in the industry. The selling profit center does not sell in the outside market when there is excess capacity in the industry. The buying profit center may purchase from outside vendors even though there is capacity available inside the company. Thus the company, as a whole, may not be optimizing its profits. In a situation of insufficient capacity in the industry, the buying profit center may be unable to obtain products it needs from the external market, whereas the selling profit center is able to make profits by selling the product in the external market. This situation occurs when demand is high and industry capacity is low. Here also, the company, as a whole, may not be able to optimize profits. Sourcing constraints When there is an excess or shortage of industrial capacity, the sourcing decisions taken by the company are vital. A company may allow its buying profit center to buy goods from outside, if the profit center is getting a better deal in terms of quality, price and service. In the same way, a selling profit center may be allowed to sell its products in the open market if it gets a better profit by selling in the market. Whatever be the case, the management should not get bogged down by pressures within the company and should try to take decisions that optimize the profit of the company.
Profit Sharing
Under this method, the product is transferred to the marketing unit at the standard variable cost. After the product is finally sold, the business units share the profit earned. But, this method may lead to disagreements over the way the profit is divided between the two profit centers. Sometimes, senior management has to intervene to settle these disputes. As the profits between units are divided arbitrarily, it does not reflect accurately the profitability of each segment. Also, as the manufacturing unit's contribution depends on the marketing unit's ability to sell and the actual selling price, this may be treated as unfair by the manufacturing unit.
Negotiation
Business units of companies negotiate among themselves before taking decisions pertaining to transfer prices. The headquarters does not involve itself in formulating transfer prices and leaves it to the line managers of the respective units to establish the buying and selling prices. There are two reasons for this. Firstly, the line managers of the business units may feel powerless if they are denied any say in the transfer prices, and this may affect their motivation. Secondly, if the profits of business units are poor then the unit managers may argue that it is due the arbitrariness in setting transfer prices by the headquarters.
Product Classification
Sourcing and transfer pricing are greatly affected by the number of intracompany transfers and the availability of markets and market prices. The larger the number of intracompany transfers and the less the availability of market prices, the greater the need for more formal transfer pricing rules. If market prices are readily available, the headquarters can play a vital role in making sourcing decisions. In some companies, products are classified into various categories to help in determining transfer prices. For example, a company can divide its product portfolio into two classes before taking transfer pricing decisions. Class I products may include all those products whose transfer price the senior management at the headquarters would like to control. Class II products may include those products that can be produced outside the company without disrupting the normal workflow. These products are small in volume and are transferred at market prices.