Manufacturing companies operate differently from retailers or wholesalers. They produce goods internally before making sales to external customers. In many organisations, production and selling are handled by different divisions. When one division supplies goods to another within the same company, a pricing method must be used. This is known as transfer pricing.
Some people find transfer pricing confusing at first because it involves adding a profit element internally and later removing it in financial reporting. However, there are strong reasons why businesses use this approach.
What is Transfer Pricing
Transfer pricing refers to the price one division of a company charges another division for goods or services. Each division is treated as if it is a separate unit responsible for its own costs and performance.
For example:
| Division | Function | Action |
|---|---|---|
| Production Division | Manufactures goods | Transfers goods at a set price |
| Sales Division | Sells goods to customers | Receives goods as inventory |
Further reading:
https://www.investopedia.com/terms/t/transferprice.asp
Why Businesses Use Transfer Pricing
Even though divisions belong to the same company, they often have separate managers, budgets, and performance targets. Transfer pricing supports effective operations in several key ways.
1. Fair Performance Evaluation
Divisional profit becomes a measure of how well each part of the organisation is performing.
• The production division shows profit from efficient manufacturing
• The sales division shows profit from successful selling
This helps the company reward good performance and improve any weaker areas.
2. Better Cost Control and Efficiency
When divisions must buy and sell goods at realistic prices, it encourages:
• Lower production costs
• Improved productivity
• Better inventory management
Each division acts responsibly, as though it were an independent business.
3. Compliance With International Tax Regulations
Large companies that operate in different countries need to show profits in the correct locations for tax purposes. Transfer pricing rules help prevent tax manipulation and ensure fairness between tax authorities in different countries.
More information:
https://www.oecd.org/tax/transfer-pricing/
How Transfer Pricing Affects Inventory Valuation
When goods are transferred internally at a price that includes a profit margin, the receiving division records the goods at that higher value in its inventory.
However, until those goods are sold to external customers, any internal profit is not considered real profit for the company as a whole. It is called unrealised profit.
At the end of the financial year, this unrealised profit must be removed from the closing inventory to ensure that financial statements show only genuine, earned profit for the entire company.
This explains why businesses appear to add profit and later remove it. Each action has a specific accounting purpose.
Should Businesses Use Transfer Pricing
There are both advantages and disadvantages to this method.
| Benefits | Drawbacks |
|---|---|
| Allows fair assessment of divisional performance | Can be complex to determine a suitable transfer price |
| Encourages responsibility and efficiency | May create disagreements between divisions |
| Supports compliance with tax regulations | Risk of manipulation without proper controls |
Despite the challenges, most medium and large businesses benefit from transfer pricing because it leads to clearer accountability and more accurate financial reporting.
Conclusion
Transfer pricing is a vital accounting and management tool for organisations with multiple divisions. It ensures fair measurement of performance, more efficient operations, and accurate reporting of profit. Although the adjustments made to remove unrealised profit may seem confusing at first, they are necessary to present a true and fair view of the company’s financial position.
