Transfer Pricing

Transfer pricing

Transfer Prices ●

Transfer prices are the amounts charged by one segment of an organization for a product or service that it supplies to another segment of the same organization.

Purpose of Transfer Pricing Why do transfer-pricing systems exist? – to communicate data that will lead to goal-congruent decisions – to evaluate segment performance and thus motivate managers toward goal-congruent decisions

Purpose of Transfer Pricing Multinational companies use transfer pricing to minimize their worldwide taxes, duties, and tariffs.

Advantages and disadvantages of basing transfer prices on total costs, variable costs, and market prices.

Transfers at Cost ●

About half of the major companies in the world transfer items at cost.

Transfers at Cost What are some examples? Full cost plus a profit markup Variable costs Standard costs Actual costs Full cost

Market-Based Transfer Prices

If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort.

Market-Based Transfer Prices ●

The major drawback to market-based prices is that market prices are not always available for items transferred internally.

Variable-Cost Pricing ●

When market prices cannot be used, versions of “cost-plus-a-profit” are often used as a fair substitute.

Variable-Cost Pricing

In situations where idle capacity exists, variable cost would generally be the better basis for transfer pricing and would lead to the optimum decision for the firm as a whole.

Negotiated Transfer Prices ●

Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.

Dysfunctional Behavior Virtually any type of transfer pricing policy can lead to dysfunctional behavior – actions taken in conflict with organizational goals.

The Need for Many Transfer Prices The “correct” transfer price depends on the economic and legal circumstances and the decision at hand. ● Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort. ●

Factors affecting Transfer prices.

Multinational Transfer Pricing Example An item is produced by Division A in a country with a 25% income tax rate. ● It is transferred to Division B in a country with a 50% income tax rate. ● An import duty equal to 20% of the price of the item is assessed. ● Full unit cost is Rs100, and variable cost is Rs60 (either transfer price could be chosen). ●

Multinational Transfer Pricing Example

Which transfer price should be chosen? Rs100

Why?

Multinational Transfer Pricing Example Income of A is Rs40 higher: 25% × 40 = (Rs10) higher taxes Income of B is Rs40 lower: 50% × 40 = Rs20 lower taxes Import duty paid by B: 20% × 40 = (Rs8) ∴ Net savings = Rs2

Global Pricing Considerations

Criteria while making decisions:

Transfer

a) Tax regimes b) Local Market conditions c) Market Imperfections d) Joint-venture partner

pricing

Key drivers behind transfer pricing in Foreign Countries:

b)

Market Conditions Competition

c)

Profit for the affiliate

d)

Tax Rates

a)

Key drivers behind transfer pricing in Foreign Countries: e) Economic conditions

f) Import Restrictions g) Customs Duties h) Price Controls i) Exchange Controls

Setting Transfer Prices a) Arm’s length prices: use of market mechanism as a cue for setting transfer prices. b) Cost-based pricing (adds a mark-up)