How Transfer Pricing Affects Managerial Accounting

In managerial accounting, the transfer price is the price at which a company’s subsidiary sells goods and services to another. Goods and services can include labor, components, parts used in production, and general consulting services.

Key Takeaways

• Transfer pricing is an accounting practice that records the price one company division charges another division for goods and services.
• Subsidiaries can sell labor, manufacturing parts, and other supplies to each other.
• Transfer prices impact three managerial accounting areas: division performance, managerial incentives, and taxes.

Transfer Price and Managerial Accounting

Transfer prices affect three managerial accounting areas:

• Transfer prices determine costs and revenues among transacting divisions, affecting the performance of each division.
• 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.
• 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.

Important

Transfer pricing is regulated by Internal Revenue Service (IRS) Section 482, which advises that prices charged by one company affiliate to another, involving the transfer of goods, services, or intangibles, yield results that are consistent with the results that would have been realized if uncontrolled taxpayers make the same transaction.

Determining a Transfer Price

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.

Tax Liability

Transfer prices play a large role in determining the overall organization’s tax liabilities. If the downstream division is located in a 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.

When Does Transfer Pricing Lead Subsidiaries To Buy From Outside Sources?

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.

How Does a High Transfer Price Affect Transactions Between Subsidiaries?

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.

How Does Transfer Pricing Affect Multinational Corporations?

The transfer pricing mechanism may help companies shift tax liabilities to low-cost tax jurisdictions. Multinational corporations (MNCs) are allowed to use the transfer pricing method to allocate earnings among their subsidiary and affiliates that are part

of the parent organization. The IRS and the Organization for Economic Cooperation and Development (OECD) oversee international taxable transactions.

The Bottom Line

The transfer price impacts the performance of both subsidiaries that transact with one another. A price that is too low disincentivizes an upstream division from selling to a downstream division, as it results in lower revenues. A price that is too high disincentives the downstream division from buying from the upstream division, as costs are too high. Arriving at a fair transfer price benefits both subsidiaries and allows for favorable tax setups.