Intercompany transfer pricing: calculation methods and examples

4. Negotiated transfer pricing method

Negotiated transfer pricing method takes place when top management and company divisions negotiate transfer prices. This method can be used when there is no external market (no market price is available) and a cost-based approach is not adequate or acceptable. Negotiations can include the allocation of cost savings between the buying and selling divisions and credits for selling and marketing expenses (because the intercompany trade does not require them).

Negotiated transfer prices can (and should) be based on available cost data of the selling division so there may be an overlap between the negotiated transfer pricing method and the cost-based transfer pricing method(s).

Considerations for Negotiated Transfer Pricing Method

  • Negotiated transfer prices are especially applicable in the intercompany sale of services because there may not be a good financial measure of revenues or costs associated with their value.

  • One of the drawbacks of using the negotiated transfer pricing method is that the transfer price may reflect the individual manager’s ability to successfully negotiate prices.

  • The transfer price might be also affected by the business units’ bargaining power (e.g., larger business units may demand and accrue more benefits from the internal exchange at the expense of smaller business units).

  • Finally, the negotiated transfer pricing method often requires top management oversight and intervention in contrast to the market-based and cost-based approaches, which can be easily included in company policy.

Negotiated Transfer Pricing Method Example

Again, let’s refer to the original transfer pricing example introduced earlier in this article. Division D3 can buy widgets from Division D1 or from an external party. Clearly, if the transfer price set by Division D1 is more than $150 (which is the external vendor price), then Division D3 should buy such widgets from the external vendor. If Division D1 sets the transfer price to be below its total costs ($100 for variable and fixed cost), then Division D1 will be losing profit on this trade in the long run. In the short run and with idle capacity, the selling division would be fine with the transfer price that covers only variable cost of $70. In this case, a better approach is to establish a price in the $100-$150 range. With this in mind, top management with assistance from the finance department decides to set the transfer price as follows: total cost per widget + 50% of savings from buying internally = $100 + ($150 - $100) x 50% = $125.

As we can see, transfer pricing involves some number crunching as well as non-financial considerations.  A company should carefully review both financial and non-financial implications of establishing transfer pricing to ensure it will meet the overall company objectives for intercompany trade.

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