Transfer Pricing

You work at the multinational, multi-divisional conglomerate GloboMegaGiTechCo Inc. You head the purchasing team at Fragrance De Bebe. It’s the firm's perfumed diaper division. For babies who really like to be, uh...pampered. Your product combines perfume fragrances with specialty diapers.

For that upper class baby ready for a night out. Brands like Coco, Not Caca and L'eau de not-quite-ready-for de Toilette. To create the product, you buy diapers from one source and perfume from another. Then your team of highly trained spritzologists apply the perfume to the diapers.

Luckily, GloboMegaGiTechCo has a diaper division and a perfume division. Or maybe unluckily for you...life just got more complicated...because of transfer pricing. The company bigwigs are happy that everything stays in house. You can get all your raw materials from within the GloboMega family.

Annnnnd that’s great. But it’s also a headache. Why?

Because if you bought diapers from one vendor, you’d have a market price for them, you’d negotiate hard, and pick the best deal for your company from the 18 purveyors of fine nappies for the spirited pre-millennial set. Same deal with the perfume.

But here, that’s not the case, because you’re essentially buying from…yourself. And that’s a problem, because the prices now aren’t “market” they are kind of made up. Sorta.

Yes, you can get in the zone of a market price, but often there really isn’t a kind of market clearing price for a million nappies. Like nobody else buys them in that kind of bulk and then how do you account for shipping charges and, well, breakage or rippage or whatever else costs money in acquiring those diapers…?

Luckily, there exists the magic of transfer pricing. Transfer pricing tracks expenses for separate departments within the same firm that do internal business with each other. Like, it more or less sets the price. The goal is to fairly attribute pricing to each division, such that everyone feels equally...unfairly treated.

You can imagine that the manager of the diaper sales division has her own income statement, and she probably earns her bonus based on how profitable that division runs.

Well, if the big bad boss at corporate wants to show more profit in the GloboMega Diaper Corp., then that boss will lean on Ms. Shimmelbottom to sell, or rather to transfer price her diapers at very cheap prices, so that Diaper Corp. looks much more profitable than it really would be, were it paying market prices for its very raw materials.

Meanwhile, the same thing is going on at GloboScent Corp. The higher the price they get for the perfume they send you, the better their numbers will look. More bonuses. More promotions. More cover stories in Perfume Industry Monthly.

On the other side of things, you have a similar incentive to get prices down. The less you pay for the raw materials, the better your profits look. Again, big bonuses at stake. Better chance to climb the corporate ladder.

Yes, these accounting gymnastics may seem silly. All the money just ends up in the same big mega glop huge corporate bottom line in the end, right? If you send money to GloboMega Diaper Co., it shows up on their quarterly reports to Wall Street. The net number to Globo won’t change whether the diapers and perfume are transfer priced expensive...or transfer priced cheap.

It’s all GloboMegaGiTechCo’s money in the end. Lliterally. But it matters for internal accounting.

There are the bonuses and the egos and all the corporate Game of Thrones stuff. But there are legitimate business reasons too. Transfer pricing allows accountants to figure out the true cost and profitability of different products. This information allows GloboMega to make informed decisions. What products are worth keeping? Which ones should it expand?

If a manager just grabbed a bunch of diapers or walked off with a drum full of perfume, without charging those costs to their division, then when all the beans are counted at the end of the day, it would be impossible to track the costs it took to actually make those items. And the resulting numbers would then cloud how well or poorly each division is doing….

And you can imagine that there have been times in business when an internal division is simply poorly run.

Like...what if the perfume business could only make that perfume for $100 a gallon - but the manager of Fragrance De Bebe could buy that same identical perfume from another vendor for $70 a gallon? Since the perfumed diaper people are bonused on profits, why shouldn't they be allowed to buy the product the best way they can buy it?

And it may mean that the GloboScent division should in fact be tossed out like an old diaper. And shut down. So transfer pricing shines a bright light on the line operations of a business, and allows managers to figure out the true value of each of their products.

Without accurate transfer pricing, a big company like GloboMega wouldn't be able to identify which products are really profitable divisions and which ones are a drag on the firm’s finances. So, to get the diapers from GloboMega's diaper division, you’ll have to pay for the product.

It’s time to go over to the Diaper Co. and buy some diapers. How do you set the price?

There are three basic methods...first some details about the diapers: A package of 100 diapers retails for $50. It costs the diaper unit $20 to produce. Okay, now here are the three methods:

One: pay for the cost of producing the diapers.

So, under the first method, you'll just reimburse the diaper unit for their costs. You'd pay them $20 for 100 diapers.

The second method: full retail price. You'd give Diaper Co. the $50 they would have gotten if the diapers had sold at the store.

Third method: a negotiated amount in-between. Some figure higher than the cost, but not quite full price. Basically, you'd get on the phone with some sales guy at Diaper Co. and work out a deal.

The transfer price you pay will depend on the situation. If Diaper Co isn't working at capacity, a price at cost, or close to it, makes sense. They can crank up production pretty easily without causing a problem. The diapers you get wouldn't get made if you didn't want them.

However, if Diaper Co. is constantly selling out, then a transfer price at or near retail price would make sense. They have orders piling up. They're having trouble filling them all. Every diaper you take is a diaper they can't sell to a customer. You're literally costing them sales. So you should be treated just like any other customer.

Turns out Diaper Co. is near capacity. You’ll have to pay near full price. However, you negotiate a volume discount. You’ll pay $45 per package of 100 diapers.

Meanwhile, you get another 10% off by promising that Jimmy, the best softball player at Fragrance De Bebe, will play for Diaper Co. at the next company picnic. So you end up paying $40.50 per 100-count package.

Time to buy the perfume.

When you call over GloboScent Corp., they have a deal for you. Ode de Tide Water hasn’t been selling very well. They have a lot of it sitting in the warehouse and are happy to get rid of it. You can basically get it at cost.

Plus, you talk them into letting you use some of their K-cup budget just to take the extra barrels of perfume off their hands.

So yeah. That’s transfer pricing.

We could go into it in more depth, but for now, we’ll just start with a spritz...