Transfer Pricing1

Presented By:Group 9

TRANSFER PRICING

 Transfer price is the price which one unit of the

organization charges for a product or service supplied to another sub-unit of the same organization.  The transfer price used in the organization will have significant effect on the financial performance of different divisions.  Transfer pricing has a significant bearing on the revenues, costs and profits of responsibility centres.

Transfer Pricing Objectives Divisonal Autonomy

Optimal Resource Allocation

Performance Assessment OBJECTIVES

Organisational Goal Congruence

Divisonal Managerial Motivation

Requirements of Transfer Price:-

 Transfer price should be objectively determinable.  It should be equal to the value of the intermediate

products being transferred. The transfer price should compensate the transferring division and charge the buying division for the value of the product exchanged.  It should be compatible with the policy that maximizes attainment of a company's goal and evaluation of segment performance.

The limits within which the transfer price should fall are:-

# Minimum: The sum of selling division's marginal cost and the opportunity cost of resources used. # Maximum: The lowest market price at which the buying division could acquire the goods or services externally, less any internal cost savings in packaging and delivery. Profit: The difference between the two limits represents the savings made by producing internally as opposed to buying it from outside.

Types of transfer pricing Methods of Fixing Transfer Prices

Cost Based

Cost Price

Standard Cost

Cost plus Normal markup

Incremental

Prevailing Market Price

Market Based

Negotiated

Approximation

Bidding

Company’s O.P. remains same irrespective of the method used

Market Price

Cost Basis

Negotiated

1. Production Divison(S.P./gallon)

$ 13

$ 8.8=1.1*8

$ 10

Revenue

$1300

$880

$100

(V.C.-$2/gallon)

$200

$200

$200

(F.C.)

$600

$600

$600

O.P.

$500

2.Transportation Divison(S.P./gallon)

$18

$14.08=1.1*(8.8+1+3)

$16.75

Revenue

$1800

$1408

$1675

(T.I.C.)

$1300

$880

$100

(V.C.-$1/gallon)

$100

$100

$100

(F.C.)

$300

$300

$300

O.P.

$100

3.Refining Divison(S.P./gallon)*

$52

$52

$52

Revenue(price*50)

$2600

$2600

$2600

(T.I.C.)

$1800

$1408

$1675

(V.C.-$4/gallon)

$400

$400

$400

(F.C.)

$300

$300

$300

O.P.

$100

Rank 1

Rank 2

Rank 2

$80

$128

$492

Rank 3

Rank 2

Rank 1

$200

$275

Rank 3

Rank 1

$225 Rank 2

Cost Based Methods (i) Cost Price  goods or services are transferred at their actual cost of

production.

 useful for those units where the responsibility of profit

performance is centralized.

 the selling division does not earn any profit and the purchasing

department's profit is inflated.

Cost Based Methods (ii) Standard Cost  Under this method, all transfers are valued at standard cost.  The supplying division normally absorbs variances from standard cost.  Once the standards are properly set, operation of this system is simple.  Profit performance of each division cannot be measured and therefore, the responsibility of profit performance is centralized.

Cost Based Methods (iii)Cost Plus a Normal Mark-up  Under this method, the transfer price includes, besides unit cost

of production, some profit margin or normal mark-up.  The price received/ paid by the selling and purchasing department respectively includes an element of profit.  The mark-up can be determined in two ways. It is either a target profit fixed by the management or a profit margin equal to that, which competing organizations may reasonably be expected to realize. When the second basis is adopted, the transfer price approximates the market price.

Cost Based Methods (iv) Incremental Cost  When the entire production of the selling division is transferred

internally and there are no outside customers, incremental cost includes all variable cost plus any fixed costs directly attributable to internal transfer. Such a transfer price is not appropriate for measurement of divisional performance.  When there are outside customers for the goods and the division is not able to produce the full demand (from the outside customers as well as sister divisions), the incremental cost to the selling division would be the revenue lost on sales to outside customers i.e. the market price. Such a cost is useful for profit centre analysis.

Market Price Based Methods The market price can be arrived at in three ways: (i) Through prevailing market price if there is an active market for goods and services transferred between divisions. The prevailing price is adjusted for discounts and selling costs, which are not involved in inter- divisional exchange. This method has the following merits: (a) market prices represent alternatives to the division. That is market price will be the basis, if the selling division sells the goods to the outside customers and the buying division purchases from outside suppliers. (b) market prices are neither arbitrary nor artificial. Such a transfer price gives the following advantages to the selling division: no risk of bad debt no direct promotional expenses. (c) The buying department will have the advantages of assured delivery schedule and full customer service.

Market Price Based Methods (ii) Where easily identified market prices are not available,costs plus a normal profit provides a reasonable approximation of the market price. (iii) Where the market price is not available, bids are invited from different manufacturers and the lowest bid is taken as the market price and used for internal transfer pricing. The limitation of this method is that the bidders may either tender spurious bids or may not bid at all, knowing that the firm does not intend to buy goods but intends to use the bid for internal purposes.

Negotiated Prices Method  The inter-divisional transfer price can also be based

on a price mutually agreed upon by the buying and selling divisions through negotiations.  The advantage of this method is that it will lead to a transfer price, which is mutually advantageous to both the divisions and the organization as a whole.  This method, however, can be applied only in those situations in which the selling division has the choice of customers and the purchasing division has choice of suppliers.

Special Pricing:Dual (Two-way) Prices 

Under this method of transfer pricing, the transferring division is credited with one price and the acquiring division is charged at a different price.

 This method eliminates the possibility of conflict caused by a

single transfer price in which case one segment receives relatively less contribution of profit because the price setting process entitles the other segment to receive relatively more.

Comparison of Different Transfer Pricing Methods Criteria

Market Price Based Methods Yes, when the markets are competitive Yes, when the markets are competitive

Cost Based Methods

Motivate management effort

Yes

Preserves sub-unit autonomy

Yes, when the markets are competitive No market may exist or markets may be imperfect or in distress

Yes, when based on budgeted costs. Less incentive to control costs if transfers are based on actual costs No, because it is rule based

Achieve goal congruence Useful for evaluating unit performance

Other factors

Often, but not always Difficult, unless transfer price exceeds full cost

Useful for determining full cost of products and services, easy to implement

Negotiated Price Method Yes Yes, but transfer prices are affected by bargaining strength of divisions Yes

Yes Bargaining and negotiation take time. Price may need to be revised repeatedly as conditions change.

 Conclusion:

 There is no method, which meets all the criteria. The transfer price a

company will eventually depends on the economic circumstances and the decision at hand.

  The following general guideline (formula) is a helpful first step in setting

a minimum transfer price in many situations:  Minimum Transfer Price = Additional outlay cost per unit incurred because goods are transferred +Opportunity cost per unit to the organization because of the transfer  Additional outlay cost- means the additional cost of producing and

transferring the products or services.  Opportunity cost -maximum contribution margin foregone by the selling sub-unit, if the products or services are transferred internally.