Happy Transfer Pricing

A newly appointed Managing Director of a Biotech Company, who believed in participative leadership, wanted to increase organizational efficiency of his organization and save costs. So, he invited all the departmental managers for generating ideas but the brain storming session turned into a heated debate and counter firing. Disappointed Managing Director was puzzled as to how all the negative interactions and other hidden ego issues between these managers should be solved or otherwise the work environment and the business will suffer hugely.

He shared his worries with his old friend who was a risk consultant and he immediately spotted the role of management accounting which plays a powerful role in encouraging or discouraging such interactions. The management accounting system recognizes the interactions of different responsibility centers through Transfer Pricing, a system of pricing product or services transferred within the same organization.

The Managing Director said that Transfer Pricing is not a big issue as he has appointed a renowned tax advisory firm. His friend told him that Transfer Prices are much more rooted than this and are prevalent in organization than most managers realize. Consider the charge which the advertisement department receives from maintenance department for janitorial services or a monthly charge for telephones, security services, data processing, or legal and personnel services. This cost distribution is internal Transfer Prices. There are three main reasons for Transfer Pricing within the firm. These are control purpose i.e. setting incentives and performance measures, decentralized planning decisions and international tax etc reasons. All these factors should be considered in setting Transfer Prices.

"What does that mean?" asked immediately the Managing Director as he had thought that Transfer Pricing issue was already taken care of in his organization. His friend then told him that Transfer Pricing is used for control and planning purposes in a decentralized organization. To determine performance of a manager and his profit and investment centre requires use of Transfer Pricing when goods or services are transferred within the organization.

Transfer Pricing should lead to performance measures that discriminate between good and bad managers. In other words, manager's responsibility centre should not be penalized by Transfer Prices that are affected by the performance of the manager of other responsibility centre. For e.g. manager of engineering department should not be able to charge the manager of production department for cost overrun due mistake the engineering department made.

Similarly, in case of planning decisions, the managers of a responsibility centre make certain input and output decisions. But many a times he is not allowed to go outside the organization for sourcing or selling. In such a situation manager can resort to such decisions or maintain same level of efficiency in absence of any competitive pressure which are not consistent with the entire organization's goal. Thus Transfer Price should be less subject to managerial discretion to encourage operational efficiency and organizational harmony.

He immediately asked his friend to look into the controls related to performance measures and existing transfer pricing practices within his organization.