How do you evaluate the impact of transfer pricing on managerial incentives and decision making?

1 Transfer pricing objectives

The main objectives of transfer pricing are to align the interests of managers with the overall goals of the company, to provide accurate information for performance evaluation and budgeting, and to comply with tax and regulatory requirements. However, these objectives may not always be consistent or achievable with a single transfer pricing method. For example, a transfer price that reflects the external market conditions may not be fair or feasible for internal transactions, or a transfer price that minimizes the tax liability may not encourage optimal resource allocation.

2 Transfer pricing methods

There are different methods of setting transfer prices, such as market-based, cost-based, negotiated, or hybrid methods. Each method has its advantages and disadvantages, depending on the context and the criteria used to evaluate them. For instance, a market-based method may be preferred if there is a competitive and transparent external market for the intermediate product, as it can provide a clear benchmark and incentive for efficiency. However, a cost-based method may be more suitable if the external market is distorted or absent, as it can ensure cost recovery and avoid disputes.

3 Transfer pricing effects

The choice of transfer pricing method can have various effects on the behavior and decisions of managers. Negotiated or hybrid methods may provide more flexibility, but they can also lead to conflicts and inefficiencies. Market-based or cost-based methods may impose more constraints, but they can also reduce the incentive to collaborate or innovate. The transfer price can encourage overproduction and profit shifting if it is higher than the marginal cost of the supplying division, while a lower transfer price may discourage production and profit sharing. A transfer price equal to the marginal cost may achieve optimal resource allocation, but it may not reflect the opportunity cost or value added by the supplying division. A market-based transfer price may reflect the market demand and competition, but it can also be affected by external fluctuations or disruptions. An internal cost or standard-based transfer price may reflect efficiency and quality of operations, but it can also be influenced by factors within the control of managers.

4 Transfer pricing challenges

Evaluating the effects of transfer pricing is a difficult task, as it involves many challenges and trade-offs. For instance, the availability and reliability of information needed for the transfer pricing method may not be easy or possible to obtain or verify. Additionally, the complexity and variability of situations must be taken into account, as external market conditions may vary by region or time and internal transactions may involve different products or services. Furthermore, the transfer pricing method must be aligned with the strategic and operational objectives of the company, however this may not always be compatible or balanced. For example, the transfer pricing policy may conflict with the tax or regulatory policy, or create unintended incentives for managers.

5 Transfer pricing best practices

The evaluation of transfer pricing effects should be guided by some best practices, such as involving and communicating with stakeholders, reviewing and revising assumptions and methods, and integrating and coordinating systems and processes. The transfer pricing policy should be developed and implemented with the participation of relevant parties, such as managers, accountants, auditors, tax authorities, and regulators. It should also be communicated clearly to avoid misunderstandings or disputes. Furthermore, the policy should be reviewed periodically to ensure its validity and suitability. It should also be integrated with other systems and processes of the company, such as budgeting, costing, reporting, auditing, and taxation. Appropriate tools and techniques should be used to support and monitor the policy, such as software, databases, models, and benchmarks.