How does transfer pricing affect managerial accounting?

In managerial accounting, the transfer price represents a price at which one subsidiary, or upstream division, of the company sells goods and services to the other subsidiary, or downstream division. Goods and services can include labor, components, and parts used in production and general consulting services.

Transfer prices affect three managerial accounting areas. First, transfer prices determine costs and revenues among transacting divisions, affecting the performance evaluation of divisions. Second, transfer prices affect division managers' incentives to sell goods either internally or externally. If the transfer price is too low, the upstream division may refuse to sell its goods to the downstream division, potentially impairing the company's profit-maximizing goal. Finally, transfer prices are especially important when products are sold across international borders. The transfer prices affect the company's tax liabilities if different jurisdictions have different tax rates.

Transfer prices can be determined under the market-based, cost-based, or negotiated method. Under the market-based method, the transfer price is based on the observable market price for similar goods and services. Under the cost-based method, the transfer price is determined based on the production cost plus a markup if the upstream division wishes to earn a profit on internal sales. Finally, upstream and downstream divisions' managers can negotiate a transfer price that is mutually beneficial for each division.

Transfer prices determine the transacting division's costs and revenues. If the transfer price is too low, the upstream division earns a smaller profit, while the downstream division receives goods or services at a lower cost. This affects the performance evaluation of the upstream and downstream divisions in opposite ways. For this reason, many upstream divisions price their goods and services as if they were selling them to an external customer at a market price.

If the upstream division manager has a choice of selling goods and services to outside customers and the transfer price is lower than the market price, the upstream division may refuse to fulfill internal orders and deal exclusively with outside parties. Even though this can bring extra profit, this may harm the overall organization's profit-maximizing objective in the long term. Similarly, a high transfer price may provide the downstream division with the incentive to deal exclusively with external suppliers, and the downstream division may suffer from unused capacity.

Transfer prices play a large role in determining the overall organization's tax liabilities. If the downstream division is located in the jurisdiction with a higher tax rate compared to the upstream division, there is an incentive for the overall organization to make the transfer price as high as possible. This results in a lower overall tax bill for the entire organization.

However, there is a limit to what extent multinational organizations can engage in overpricing their goods and services for internal sales purposes. A host of complicated tax laws in different countries limit the ability to manipulate transfer prices.