(continuing from Nature and Types of Transfer Pricing – Part I)

When making inter-company deliveries at market prices, all of the divisions can realize profit. The amount of the profit is a true indicator for the effectiveness of their activity. The market price is a criterion for the profitability of the whole chain of inter-company deliveries. The buyer buys from the seller as long as his production responds fully to his requirements for quality, design, functionality, etc. If the seller is not competitive, then the buyer is free to buy from other vendors. At the same time, the seller is free to reject inter-company deliveries if he prefers to sell to external buyers.

2) Transfer prices on the basis of contractual prices
The contractual market price is the price which the structural divisions negotiate and which for different reasons is different from the market price. For example, the inter-company exchange can be done in conditions different than the market ones and this is a reason the partners to negotiate directly transfer price. The big volume of internal purchases, the lower stock and the administrative expenses are the arguments the buyer to request the lower price.
The usage of some non-market approach is most frequently used in case when there aren’t competitive external markets or when for some external reasons there can’t be obtained competitive pricing information. A limiting factor for the non-market methods of pricing is the individual character of the products, especially products which are with special construction, manufacture, function, etc. The centralized way of management decisions making is also an important factor for the popularity of the non-market methods of the transfer pricing.

3) Transfer prices on the basis of expenses
Among the advantages of this method is the fact that the company has at its disposal the necessary output information. Also the method is easy to be understood and convenient for application. It’s mostly used when there is a centralized company management.
The disadvantage of this method is the lack of signals when a certain inter-company transfer is advisable and when not. When using this method only the manufacturing unit which is at the end of the manufacturing-technological chain and is being sold to external consumers, is the one that realizes profit. The rest of the structural divisions are with no motivation. Another important drawback is the fact that the structural divisions are not interested to exercise control over their costs. This way, the last division accumulates the inefficiency of the rest of the divisions.