The rapid advances in technology, communication, and transportation have yielded to a large number of multinational enterprises that bear the flexibility to place their enterprises and activities anywhere in the world. The main rationale of transfer pricing is to render most favourable decision making within a decentralized organization so as to maximize the profit of the organization. A transfer price integrates the cost one sub-entity of a corporation charges for a given product or service supplied to the next sub-entity within the same corporation. The sub-entities may be profit centres, cost centres, or investment centres.
Pear Ltd central management's adoption of alternative transfer prices may possess significant impact on aspects such as motivation, performance indication and autonomy across the range of Pear Ltd's responsibility centres. Motivation in this case combines goal congruence and effort and includes the aspiration to achieve a given goal outlined by the management merged with the search of those goals. Ideally, alternative transfer prices should possess properties such as promoting goal congruence, motivating management effort, useful in evaluating subunit performance, and preserving an enhanced level of subunit autonomy in decision making.
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The advantages of transfer pricing across Pear Ltd's range of responsibility centres include better, timely decisions owing to the manager's proximity to local conditions; the managers are not diverted by regular, restricted decision difficulties; managers' motivation increases since they have better control over results; and enhanced decision making that avails better training for mangers for enhanced level positions within the future. Some of the disadvantages that can be cited include lack of goal congruence among mangers within diverse parts of the organization; inadequate information available to top management; and, lack of coordination among managers in diverse parts of the organization.
Alternative methods of transfer pricing
Market-based transfer pricing
Market-based transfer pricing details when the outside market for the product is well-defined, competitive, and stable, organizations frequently tend to institute the market price as a benchmark for the transfer price. This approach, however, attracts some concerns, especially when the outside company is neither competitive nor stable. This may distort internal decision making for relying on market-based transfer prices that mirror distress prices or a variety of "special" pricing strategies. Market-based pricing overall leads to finest decisions, especially when: a) the marketplace is perfectly competitive; b) there is low interdependencies of sub-divisions; and, c) there is lack of extra costs or gains to the association in its entirety from buying or selling within the external market rather than transacting internally. Using market prices for transfers in certain conditions leads to goal congruence. Division managers will be acting in their own best interests to arrive at decisions that may be within the best interests of the organization as a whole. Nevertheless, one can argue that computing transfer prices grounded in cost will most probably make Pear Ltd to pay little attention to mitigating outlays since all expenditures incurred amid production will be recovered.
Negotiated transfer pricing
This approach features a firm identifying regulations for the computation of transfer prices. Divisional managers, in this case, are persuaded to settle or jointly agreeable transfer prices. The exact transfer price in this case hinges on the negotiating powers of the divisions. The bargained transfer price manifests a number of properties: attainment of goal congruence; critical for evaluating division performance since the transfer derives from express bargaining between the set divisions; motivating administration endeavour given that once bargained, the transfer price is autonomous of real costs of the subunit (the subunits in this case manifest every reason to direct the organization resourcefully to increase profits; and, safeguarding subunit independence since the transfer pricing flows from express negotiations between the two subunits.
Cost-based transfer pricing
In the lack of perfectly developed market-price, majority of the companies base their pricing on the manufacturing cost of the supplying sub-entity. The most prominent methods employed include: full cost, cost-plus, variable cost plus lump sum charge, dual transfer prices, variable cost plus opportunity cost. One possible restraint of full-cost-based transfer prices derives from the fact that they can yield to suboptimal conclusions for the organization as a whole. Transferring products internally at incremental cost possess the following properties: attains goal congruence; not useful for evaluating subunit performance since transfer price fails to exceed full costs.
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Transferring products internally at incremental cost fails to preserve subunit autonomy since it is rule-based and some divisions have no say in and, thus, no capability to set the transfer price. However, transferring products internally at incremental cost will motivate management effort if based on budgeted costs (actual costs are comparable to budgeted costs). If, however, the transfers are grounded are based on actual costs, Pear Ltd possess little incentive to control costs. Although, neither approach can be cited to be perfect, negotiated transfer pricing possesses more favourable properties compared to the cost-based transfer pricing. Both transfer-pricing approaches attain goal congruence; however, bargained transfer pricing assists in the estimation of subunit performance, stimulates management action, and conserves subunit autonomy, while the transfer price remain based on incremental costs fails to attain these objectives.
The benefits of utilization of alternative methods of transfer pricing between responsibility centres is that the operating managers possess the incentives to closely weigh and conduct cost-benefit analysis prior to requesting group's services or products. Similarly, the operating managers possess an inducement to pursue the job and the development undertaken by the responsibility centres. Decentralization would encourage plant managers to enhance output so as to achieve the highest profitability, and inspire plant managers to track cost cutting measures that would increase margins. Manufacturing managers would be equally motivated to design their operations as per the criteria that satisfy the marketing manager's approval, hence enhancing cooperation between the responsibility centres.
The problem that emanate from adoption of alternative transfer pricing by Pear Ltd's central management is that the contract may necessitate extensive internal negotiations with regard to cost, time, and technical specification. Similarly, Pear Ltd's divisions need to consistently "sell" their services or products to the operating division and this could possibly result in loss of morale. To the degree that the focal point of the responsibility centres is on short-term schemes stipulated by the operating divisions, the current arrangement would lead to goal congruence and motivation. Goal congruence is attained since both the central management (operating divisions) and the responsibility centres are motivated to work the organizational goals such as enhancing the environment. The operating divisions would be highly motivated to utilize the services of the responsibility centres so as to attain the objectives outlined for them by the administration.