Transfer PricingTransfer Pricing

UIAMS, Panjab University, ChandigarhUIAMS, Panjab University, Chandigarh

Transfer PricingTransfer Pricing

Outline:Definition of Transfer PricingObjective of Transfer PricingTransfer Pricing Methods

Definition of transfer pricingDefinition of transfer pricing

• A transfer price is charged when one division sells goods and services to another division

• TP is important in case of intra-company transfer of goods and services: when a company use division performance measure to assess both the external and internal profitability of product and services

• It affects the revenue and costs of divisions involved

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Value placed on transfers within an organization, Value placed on transfers within an organization, used as a means of allocating costs to various profit used as a means of allocating costs to various profit centers is transfer pricing.centers is transfer pricing.

The price at which divisions of a company transact The price at which divisions of a company transact with each other. Transactions may include the trade of with each other. Transactions may include the trade of supplies or labor between departments.supplies or labor between departments.

Transfer prices are used when individual entities of Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as a larger multi-entity firm are treated and measured as separately run entities. separately run entities.

Transfer PricingTransfer Pricing

A transfer price is the price one subunit chargesfor a product or service supplied to another

subunit of the same organization.Intermediate products are the products

transferred between subunits of an organization.

Objectives of TPObjectives of TP1)1) Measuring Divisional performanceMeasuring Divisional performance

2) Goal congruence and optimal decision making2) Goal congruence and optimal decision making

3) Enable reliable performance appraisal of each independent 3) Enable reliable performance appraisal of each independent unitunit

4) Divisional managers should develop offers of TP that reflects 4) Divisional managers should develop offers of TP that reflects the cost structure of their divisions and also maximize the cost structure of their divisions and also maximize divisional autonomydivisional autonomy

Possible outcomesPossible outcomes

• 1) Provide each business unit with the relevant information.

• 2) It needs to determine optimum trade off between companies cost and revenue.

• 3) It should induce the goal congruence decision to improve units profit.

• 4) It should help to measure the economic performance of individual business unit.

• 5)The system should be simple to understand and easy to administer.

Criteria for validity & acceptability of TPCriteria for validity & acceptability of TP

1.1. TP should be objectively determined.TP should be objectively determined.

2.2. TP should be equal to the value of the TP should be equal to the value of the intermediate product being transferred.intermediate product being transferred.

3.3. TP should be compatible with a policy that TP should be compatible with a policy that maximizes attainment of the companies goal and maximizes attainment of the companies goal and evaluation of segments performance.evaluation of segments performance.

Factors affecting TP Factors affecting TP Performance measurement.Performance measurement.

Capability of accounting system.Capability of accounting system.

Custom duties.Custom duties.

VAT.VAT.

Taxes on profitTaxes on profit

Uses of TPUses of TP1)1) Price setting for services performed by Price setting for services performed by

business unit.business unit.2)2) A mean of evaluating financial performance of A mean of evaluating financial performance of

business unit.business unit.3)3) Determining the contribution to net profit by Determining the contribution to net profit by

profit centers in organization.profit centers in organization.

4)4) Reduce in corporate taxes paid.Reduce in corporate taxes paid.

5)5) Reduce in VAT , excise, tariffs.Reduce in VAT , excise, tariffs.

Fundamental PrincipleFundamental PrincipleThe transfer price should be similar to The transfer price should be similar to the price that would be charged if-the price that would be charged if-

The product were sold to outside The product were sold to outside customers orcustomers or

Purchased from vendorsPurchased from vendors..

TP policiesTP policies That refers to selection of policies that That refers to selection of policies that

would govern the calculations of such would govern the calculations of such prices under various circumstances. prices under various circumstances.

The concern of TP policies are with The concern of TP policies are with developing a TP system that allows-developing a TP system that allows-

1)Performance measurement1)Performance measurement2)Decision optimization2)Decision optimization a) Optimal utilization of resourcesa) Optimal utilization of resources b) Cost of goodsb) Cost of goods c) Services transferred between unitc) Services transferred between unit d) Opportunity cost, mkt. priced) Opportunity cost, mkt. price

Fundamental decisionsFundamental decisions Should the company produce the product Should the company produce the product

inside the company or purchase from out inside the company or purchase from out side vendor ?side vendor ?

This is sourcing decision.This is sourcing decision.

If produced inside at what price should the If produced inside at what price should the product be transferred between profit product be transferred between profit centers? centers?

This is transfer pricing decision.This is transfer pricing decision.

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• Transfer pricing should be such that it provides the appropriate incentives to division managers and also promote goal congruence.

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• Best TP system is the one that helps managers to make decisions that are in the best interest of the firm as a whole

Transfer-Pricing MethodsTransfer-Pricing Methods

Dual TP

Cost-based transfer prices

Negotiated transfer prices

Market-based transfer prices

Variable cost TP

Market priceMarket price

• Market price: the prevailing prices in the external markets at the time of transfer is made.

• When for the intermediate product, the market is there and that is competitive, then this method is appropriate

Market-Based Transfer PricesMarket-Based Transfer Prices

By using market-based transfer pricesin a perfectly competitive market, acompany can achieve the following:

Goal congruenceManagement effort

Subunit performance evaluationSubunit autonomy

Market-Based Transfer PricesMarket-Based Transfer Prices

Market prices also serve to evaluate theeconomic viability and profitability

of divisions individually.

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• Advantages: – existence of a guaranteed and competitive

market and assurance of good quality products.• Disadvantages:

– When the prices are available and market does not exist, it may not be truly representative . e.g. the selling division is operating below capacity.

– Is difficult to employ this method in a period of rising prices

2) Full cost with or without a profit 2) Full cost with or without a profit markupmarkup

• Uses actual fixed and variable manufacturing as the transfer price

• Cost of direct materials, direct labour, , variable overhead and a portion of fixed overhead are included in the cost of product

• In full cost plus mark up method, a predetermined percentage is added to the cost

Cost-Based Transfer PricesCost-Based Transfer PricesIf competitive prices are not available transferprices may be set on the basis of Cost-Plus a profit.Two decisions must be made in a cost based TP sys.1)How to define cost.2)How to compute the profit markup.The usual basis is standard costs.Actual cost should not be used because production inefficiencies will be passed on to the buying profit center.

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• Advantage: – simplicity of method

• Disadvantages:– Sub-optimal decision making may occur– No incentive to selling department to bring

costs down

3) Variable cost TP3) Variable cost TP

• Uses actual variable manufacturing costs as the basis for establishing TP

• This method provides the lowest price at which the transfer should be made

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• Advantages:– Ensures the best utilization of facilities

because the contribution margin is used as a basis for decision making

• Disadvantages:– Performance evaluation of the division

becomes difficult as and meaningless as the fixed costs have yet to be covered

Negotiated TPNegotiated TP

• Allows the buying and supplying division to bargain with each other and then set the TP

• Is best method to use when both the divisions have equal bargaining power

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• Advantages:– Helps in preserving divisional autonomy and

leads to optimal decision in the best interest of the firm

• Disadvantages:– In case, if both the parties do not have equal

bargaining power, the negotiated price may lead to sub- optimal decisions.

Dual TPDual TP

• It may be possible that one method results in transfer prices that are more useful for evaluating performance and another method gives prices that are more appropriate for making economic decisions.

• Encourage appropriate economic decisions from the view point of organization as a whole

• Improves the reported results of each segment

Transfer-PricingTransfer-PricingMethods ExampleMethods Example

Lomas & Co. has two divisions:Transportation and Refining.

Transportation purchasescrude oil in Alaska and

sends it to Seattle.

Refining processescrude oil

into gasoline.

TP & profit share systemTP & profit share systemThis system operates as follows:-1)The product is transferred to marketing unit atStandard variable cost. 2)After selling of product the business unitShares the contribution earned which is Selling price-VC& marketing cost.

Problems of profit sharing systemProblems of profit sharing systemArgument over the way of dividing profitsbetween two profit centers.Arbitrary dividing up the profit between unitsdoes not gives valid information on the profit-ability of each unit.The mfg. units contribution depends upon the marketing units ability.Manufacturing unit may perceive this unfair bad situation.

RecommendationsRecommendationsIf competitive prices are not available , TP may set on the basis of cost plus profit, eventhough such TP may be complex to calculateand the results less satisfactory than a market based price. Cost based TP can be made at std.Cost +PROFIT margin, or by the use of TWO-STEP PRICING SYSTEM.In tsps the mfg.units revenue is credited at the Outside sales price and the buying unit is chargedThe total std. cost. The difference is charged to HQ.

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