Transfer pricing

1. TRANSFER PRICING

2. INTRODUCTION–TRANSFER PRICE
The price at which divisions of a company
transact with each other. Transactions may
includes the trade of supplies or labour
between departments. Transfer prices are
used when Individual entities of a larger multi
entry firm are treated and measured as
separately run entities.

3. DEFINITION-TRANSFER PRICING
Transfer pricing is the setting of the price for
goods and services sold between related
legal entities with an enterprise.
E.g.: If a Subsidiary Company sells goods to
a parent company , the cost of those goods
is the transfer price.

4. Objectives of Transfer pricing
1. To provide each division with relevant info required to make an
optimal decision
2. To promote goal congruence
3. To motivate divisional managers to take good economic
decision which will improve the divisional profits and ultimately
the overall profits
4. To foster a commercial attitude in those who are responsible for
the performance of profit centres
5. To optimize the allocation of companies financial resources
6. To optimize the profit of a concern over a short period
7. To help in measuring divisional performance
8. To estimate accurate earnings on proposed investment
decisions
9. To assist in decision making for buy or sell, or process it further
and choosing a better alternative production methods
10. To motivate divisional manager and to retain divisional
autonomy
11. To ensure minimum intervention by top management

5. Criteria for transfer pricing system
1. Neutrality – system should not distort the
way in which the business behaves, a
control system reduces the efficiency of the
process is clearly unsatisfactory
2. Equity – a system should not prevent the
decisions from reporting meaningful profit
figures, the whole idea of the divisional
organisation is debased if the system
prevents this from happening
3. Administrative convenience – system
should not be clumsy and expensive to
operate that it starts to cost more than the
benefits it provides

6. Requisites of a sound transfer pricing system
1. It should be simple to understand and easy to operate
2. It should enable fixation of fair transfer prices for output
transferred or service rendered
3. The divisional manager must be given autonomy and freedom to
sell in the open market. Does not mean complete autonomy
4. The unit/division should have free access to various sources of
market information
5. Negotiations to be there for buying and selling divisions
6. Rules must be framed to guide negotiations between divisions
7. In case of failures it should be resolved through arbitration
8. Top management should discourage prolonged arguments
between divisions
9. Transfer prices to be reviewed annually or as dictated by the
demand and supply conditions in the market
10. When transfer prices are based on market price, long term
competitive and normal prices must be considered
11. Transfer pricing and ground rules can be reviewed periodically
depending on change in business conditions

7. Benefits of transfer pricing policy
1. Divisional performance evaluation is made easier
2. It will develop healthy interdivisional competitive spirit
3. Management by exception is made possible
4. It helps in coordination of divisional objectives in achieving
org goals
5. It provides useful info to the top management in making
policy decisions like expansions, subcontracting, closing
down of a division, make or buy decisions
6. Transfer price will act as a check on supplier’s prices
7. It fosters economic entity and free enterprise system
8. It helps in self-advancement, generates high productivity
and encouragement to meet the competitive economy
9. It optimizes the allocation of company’s financial
resources based on the relative performance of various
profit centres, which in turn are influenced by transfer
pricing policies

8. KEY ISSUES-TRANSFER PRICING
Revenue
basis
Preferred
Customers
Preferred
suppliers

9. Revenue Basis : The Manager of a subsidiary
treats its same manner that he would price of a
product sold outside of the company. It forms part of
the revenue of his subsidiary, and is therefore
crucial to the financial performance on which he is
judged .
Preferred Customers : If the Manager of a
subsidiary is given the choice of selling either to a
downstream subsidiary or to outside customers,
then an excessively low transfer price will lead the
manager to sell exclusively to outside customers,
and to refuse orders originating from the
downstream subsidiary.

10.  Preferred Suppliers : If the manager of
a downstream subsidiary is given the choice of
buying either from an upstream subsidiary or an
outside supplier, then an excessively high transfer
price will cause the manager to buy exclusively from
outside suppliers. As a result, the upstream
subsidiary may have too much unused capacity, and
will have to cut back on its expenses in order to
remain profitable.

11. METHODS – TRANSFER PRICING
Market Based
Adjusted Market
rate
Negotiated
Contribution
Margin
Cost – Plus
Cost Based

12. Market Based Transfer pricing : The
simplest and most elegant transfer price is to use the
market price. By doing so, the upstream subsidiary can
sell either internally or externally and earn the same
profit with either option. It can also earn the highest
possible profit, rather than being subject to the odd
profit vagaries that can occur under mandated pricing
schemes.
Adjusted Market Rate Transfer Pricing : If
it is not possible to use the market pricing technique just
noted, then consider using the general concept, but
incorporating some adjustments to the price. For
example, you can reduce the market price to account for
the presumed absence of bad debts, since corporate
management will likely intervene and force a payment if
there is a risk of non-payment

13.  Negotiated Transfer Pricing : It may be
necessary to negotiate a transfer price between subsidiaries,
without using any market price as a baseline. This situation
arises when there is no discernible market price because the
market is very small or the goods are highly customized. This
results in prices that are based on the relative negotiating
skills of the parties.
 Contribution margin Transfer Pricing : If there
is no market price at all from which to derive a transfer price,
then an alternative is to create a price based on a
component’s contribution Margin. In this case, markup
depends on overall contribution to organisational profit

14. Difficulties in identification of market price
Prices on the open market will vary between
suppliers because of :
1. Special discount for particular customers
2. Quantity discounts
3. The extent to which delivery charges are
included
4. Deliberate dumping (at distress prices) by a
supplier who has built-up excess
inventories
5. The extent of after sales service provided

15. Advantages
1. Market price truly represents opportunity
cost
2. Actual historical costs fluctuate from time to
time and are not readily available. Whereas
market prices are easily available
3. The current performance of both the buying
and supplying divisions can be assessed in
the light of currently existing conditions
4. Variances between current and predicted
prices provide useful control data

16. Limitations
1. Resistance from the buying divisions
2. Market price fails to become opportunity cost when the company is a
price leader or a monopolist
3. Market prices may not be available for intermediate products
4. Cost prices are available from internal records, whereas market prices
varies
5. Difficulties in interpretation of market price – ex-factory, price to the
wholesalers, price to the consumers
6. Market prices may be fluctuating, hence there may be difficulties in
fixation of these prices
7. Market price info may not be available readily, if product is made to
the specification of the receiving division
8. When production is for captive consumption and when the market
price may not prevail to that product may present difficulty in fixation
of transfer price
9. In inflationary conditions the market price itself will not be a good
measure to fix transfer price due to frequent change in the prices
10. Inclusion of profit in stocks will not be allowed by the auditors
11. Market prices consist of selling and distribution overheads which will
not be incurred in inter unit transfer

17. Principles
1. Inter division transfer prices should be
determined by negotiation between the
buyer and the seller
2. Negotiators should have access to full data
on alternative sources and markets and
information about market prices
3. Buyers and sellers should be completely
free to deal outside the company

18. Limitations
1. Business like attitude amongst divisions of a company
2. Agreed transfer price between divisions of a company will
depend on negotiating skills and bargaining power of the
managers involved and the final outcome may not be close to
optimal level
3. There is clash of interest and management intervention
becomes necessary
4. Time consuming exercise for the managers of the divisions
5. Personal bias may exist between divisional managers who sit
for negotiating the transfer price
6. The more powerful division may have its way
7. Goal congruence may be sacrificed, adversely affecting the
overall company profits
8. In fixation of negotiated prices, both the units should spend
enormous time and resources
9. Measurement of divisional profitability may depend on the
negotiating skills of the managers who have unequal bargaining
powers

19. Opportunity cost transfer pricing
It recognises the minimum price that a selling
division would be willing to accept and the
maximum price that the buying division will be
willing to pay.
These minimum and maximum prices
correspond to the opportunity cost of
transferring goods and services internally
within the organisation
It is ideal for the conditions when selling
division cannot sell and buying division cannot
buy in perfectly competitive prices

20. Determination of opportunity cost transfer pricing
1. For a selling division, the opportunity cost of transfer is greater
of the following;
 Market price of transferred product for an outside sale
 Differential production cost of transferred product
2. For a buying division the opportunity cost of transfer is lesser of
the following:
 Purchase price required to be paid if it is purchased in the open
market
 Profit that would be lost from the final product if the transferred
unit could not be obtained at an economic price
 A transfer is in the best economic interest of the company if the
opportunity cost for the selling division is less than the
opportunity cost for the buying division
 As long as the transfer price is greater than the opportunity cost
of the selling division and less than the opportunity cost of the
buying division a transfer will be encouraged.

21. Limitations
1. Since minimum and maximum price is set
between divisions, clashes can arise
2. The more powerful division may exercise
heavier bargaining power
3. Company’s overall interest may be
sacrificed or the divisional managers may
be demotivated

22. Dual transfer pricing
 One single transfer price may not be meet
the objective of goal congruence in an org.
 Two different prices are arrived at by using
two different methods
 This method is not popular as it creates
confusion both to the buyer and seller
divisions
 It is not widely used in practice
 It is a method that appears to offer an
optimal solution based on the idea that
there is no necessity to have a single
transfer price

23. Transfer pricing when unit variable cost and
selling price are not constant
Where competitive market prices exists and
the supplying division has no idle capacity and
if variable unit cost and unit selling price are
not constant then the minimum transfer price
can be fixed at:
Additional outlay cost per unit incurred to the
point of transfer + opportunity costs per unit to
the supplying division

24. Cost plus Transfer Pricing: If there is no market
price at all on which to base a transfer price, you could
consider using a system that creates a transfer price based
on the cost of the components being transferred. The best
way to do this is to add a margin onto the cost, where you
compile the standard cost of a component, add a standard
profit margin, and use the result as the transfer price.
Cost Based Transfer Pricing : You can have each
subsidiary transfer its products to other subsidiaries at cost,
after which successive subsidiaries add their costs to the
product. This means that the final subsidiary that sells the
completed goods to a third party will recognize the entire
profit associated with the product.

25. Cost based transfer pricing methods
1. Actual cost of production – the transfer price will be determined based
on the cost of production arrived as per traditional method
2. Marginal cost of production – variable cost of supplying division and
no fixed cost. Major disadvantage is that transferring division incurs
the fixed cost and not the receiving division
3. Full cost – actual cost of production with all overheads (including
selling and distribution)
4. Full cost plus – full cost of sales plus mark up or an allowance of
profit. Performance of each division and each unit can be measured
along with efficiency
5. Standard cost – cost which is predetermined based on scientific
analysis and management’s view of efficient operations and relevant
expenditure. Standards may be unrealistic or outdated creating an
unfair price for any of the divisions
6. Standard cost plus lumpsum – standard variable costs be used
together with a predetermined amount allocated to the selling division.
A predetermined charge is made for fixed costs plus a lump sum
profit. The lumpsum amount is calculated based on expected long
run transactions between the two divisions

26. Advantages
1. Profitability of the concern based on ROI is
the main barometer on which efficiency of
the management is evaluated
2. Better interfirm comparison based on the
ROI is possible
3. Cost based price is criticised when the
same is higher than the market price either
due to inefficiency or under capacity
working in the selling unit

27. Limitations
1. Profit added to the cost is fictitious and
unnecessarily inflates the asset value under
the same management
2. Auditors do not accept profits in stock
valuation
3. Inefficiency of the transferor is borne by the
receiver
4. ROI may be the good measure for
controlling performances, but this should
not be accepted very rigidly

28. Transfer pricing – general rule
 Buying division makes the economic decisions that are
optimal from the point of the total company is to transfer at
Marginal/incremental cost to the selling division
+
Implicit opportunity cost to organisation if goods are transferred
internally
 The general criterial for fixing transfer prices are:
1. Goal congruence in decision making
2. Management efforts
3. Segment performance valuation
4. Sub unit autonomy and motivation value

29. General conflicts in fixation of transfer prices
1. Goal congruence Vs performance
evaluation
2. Goal congruence Vs Divisional autonomy
3. Performance evaluation Vs profitability

30. Proposals for resolving transfer pricing
conflicts
1. Dual rate transfer pricing system & two part transfer pricing
system
2. Compromise between divisional independence and corporate
coordination is inherent in any such structure
3. Transfer price should be established very carefully as it can act
as an disincentive to the managers concerned
4. Transfer price should not be fixed to benefit one unit at the cost
of other units
5. The calculation of transfer prices should be integrated into
group planning and budgeting system
6. Managers should be made fully aware of the effects of their
activities on other divisions and not on the attainment of the
short and long term objectives of the firm

31. Guiding principles in fixing transfer prices
1. Incentive to the manager of the supplier
division
2. Goal congruence between divisional and
organisational objectives
3. Autonomy for divisional managers

32. International transfer pricing
1. Distinguishing characteristics for MNCs is
its ability to move money and profits among
its affiliated companies through internal
transfer mechanisms
2. Mechanisms include transfer prices on
goods and services traded internally,
intercompany loans, dividend payments,
leading and lagging intercompany
payments and fee and other royalty
charges

33.  Transfer pricing is a device used by MNCs
to price intercorporate exchange of goods,
services, technology and capital in a
manner to maximise overall after tax profit.
 These products and factor flow range from
intermediate and finished goods to less
tangible items such as management skills,
trademarks and patents

34. Aspects of International transfer pricing
 Financial aspects:
1. To minimise the implications of tax
2. Transfer price between nations can be manipulated to minimize
tax or import duty liability or transfer funds.
 Strategic aspects: weapon in the overall marketing strategy,
profits can be concentrated, by vertical integration
 Government attitude: very significant financial gain, checks the
price that it is not artificially low if it is a exporting country. In
the importing country tax authorities are at a look out for
unreasonably high transfer prices which will reduce local profits
and liability of income tax. Customs authorities will have a
close watch
 Company attitude: financial and strategic aims will usually be
with the aim of good corporate management

35. Objectives of International transfer pricing
1. Goal congruence
2. Transfer price prima facie should be fair
3. Impact on duty will be reduced, but to be careful while fixing up
the transfer price
4. Profit repatriation will be difficult in some countries. In that case
price to be fixed which will be advantageous to both the
countries
5. In case of two foreign subsidiaries they must deal with arm’s
length price
6. Joint ventures will create additional complications in transfer
pricing. The transfer price must satisfy both the home and
foreign ventures

36. THANK
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