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What is Transfer Pricing ? | Objectives, Methods, Need, Problem

Transfer Pricing
Contents :
  • Meaning of Transfer Pricing.
  • Objectives of Transfer Pricing.
  • Needs for Transfer Pricing.
  • Methods of Transfer Pricing.
  • Administration of Transfer Prices.
  • Transfer Pricing problems.

What is meant by Transfer Pricing ? 


Introduction :

One of the principal problems in operating a profit centre system is to devise a satisfactory method of accounting for. the transfer of goods and services from profit centre to another. Since in most companies, there are significant amounts of intra-company transactions, this problem is a common one. Various approaches can be studied for arriving at transfer prices for transactions between profit centres and the system of negotiation and arbitration that is essential when transfer prices
are used.

Meaning of Transfer Pricing :


Transfer pricing is a management control tool for decentralized organisations to control performance of their divisions. The established transfer price is a cost to the division which receives the goods and services while it will be a source of revenue, to the division which is transferring such goods or services. The transfer price affects the profitability of each division. In the same way, it will also significantly influence each division's input and output decision and thus, the total company profits.

Objective of Transfer Pricing :


A sound transfer price system should accomplish the following objectives.

1) Divisional Autonomy :
When the unit is being declared as an independent profit centre, then it must be given autonomy to carry out its functions. It should motivate the division manager to make sound decisions. The transfer prices should communicate information to the managers to take such decisions. Such information must be reliable information. The manager takes certain actions to improve the reported profit of his division. This also improves the profit of the company as a whole.

2) Divisional Performance Appraisal :
The transfer price should result in a report of divisional profits that is a reasonable measure of the managerial performance of the division. When goods are transferred from one division to another, a portion of the revenue of the supplying division becomes a portion of the cost of the receiving division. Consequently, the prices at which goods are transferred can influence each division's reported profits and there is a danger that an unsound transfer price will result in a misleading performance measure that may cause divisional managers to believe that the transfer price is affecting their performance rating unfairly. This may lead to differences amongst the managers and result in negative motivation.

3) Goal Congruence :
The prices should be set so that the divisional management's desire to maximize divisional earnings is consistent with the objectives of the company as a whole. The transfer prices should not encourage sub-optimal decision-making.


Need for Transfer Pricing :


Need for transfer pricing can be explained with the help of following points :

1) To Measure Exchange of Products and Services :
Transfer prices measure exchange of products and services between responsibility centres within a company. They include the pricing of :
i) Service rendered by service departments to user departments.
ii) Transactions between divisions entrusted with profit responsibility.
iii) Transactions between legally independent organisations but under the same management.
iv) Bilateral monopolistic conditions.

2) To Delegate Authority to Managers :
When profits are used as a measure of divisional performance, the concept of transfer pricing is conducive to the promotion of goal congruence. If the corporate management can establish profit centre by assignment of responsibility for cost and revenue and a transfer price can be established which, given a volume of sales, would cause a divisional manager to make the same decision that would be made by the top management, it can delegate unlimited authority to divisional managers.

3) To Keep Up Motivation :
Transfer pricing is needed to keep up motivation of all concerned divisions. When the managers are given autonomy for the division's working, it creates a chance for the managers to earn the fair profits. It motivates them to improve upon their performance. The fairly set transfer price also encourages the receiving division to show further improvement in the performance. This allows both the divisions to earn fair level of profit at the same time without subverting company's goal.

4) To Serve as a tool for Control:
Transfer price ensures the cost control at every division. If a company follows a discretionary transfer pricing policy and if it is also followed by divisions, obviously it will not provide any impetus to the supplying division to control its costs as it is sure about recovering all its actual costs by charging it to receiving division. Such a practice is not in the interest of the company. Thus, properly set transfer pricing policy ensures the cost control consciousness among all concerned divisions.

5) To Locate Profits to Minimize Tax :
Multinational companies use transfer pricing to minimize their worldwide taxes, duties and tariffs. The company may follow a transfer pricing policy, among its divisions, such that it will facilitate transfer of its funds from high tax bracket country to tax heaven country.

Methods of Transfer Pricing :


Introduction :

The transfer pricing issue is actually about pricing in general. The fundamental principle is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendors. It is difficult to apply this principle because there is much disagreement as to how outside selling prices are established. When profit centres of a company buy products from and sell to one another, two decisions must be made periodically for each product.
1) Should the company produce the product inside the company or purchase it from an outside vendor?
This is the sourcing decision.
2) If produced inside, at which price should the product be transferred between profit centres ?
This is the transfer price decision.

Transfer price methods can range from very simple to extremely complex. It depends on the nature of the business. These methods are given below :

A) Market-based Transfer Pricing :
The ideal transfer price is based on a well-established, normal market price for the identical product being transferred i.e., a market price reflecting the same conditions as the product to which the transfer price applies. The market price may be adjusted downward to reflect savings accruing to the selling unit from dealing inside the company.
In a competitive situation, transfer prices are more likely to be related to selling prices. But complications set in because a perfectly competitive situation is largely a theoretical assumption of economists which is rarely found in existence in reality. A market price-based transfer price will induce goal congruence if all the following conditions exist.

a) Conditions :

1) Competent People :
The managers should be interested in the long-run as well as the short-run performances of their responsibility centres. Staff involved in negotiation and arbitration of transfer prices also must be competent.

2) Good Atmosphere :
Profitability is shown in the income statements of the firms. Manager must regard profitability as an important goal. It must be a significant consideration in the judgement of their performance. They should perceive that the transfer prices are just.

3) Freedom to Outsource :
There should be alternatives for outsourcing. The managers should have authority to choose the alternative best suited for their own interests. The buying managers must be free to buy from outside and the selling managers must be free to sell outside. In these circumstances, these managers are given the right to deal with others at their own discretion. It is given by the transfer price policy. The market, thus, establishes the market price. The decision as to whether to deal inside or outside also is made by the marketplace. If buyers cannot get a satisfactory price from the inside source, they are free to buy from outside.

4) Full Information :
Managers must know about the available alternatives and the relevant costs and revenues of each alternative.

5) Negotiation :
There must be a smoothly working mechanism for negotiating contracts between business units.

b) Basis for Setting Transfer Prices :

The following are some ways by which transfer prices can be set up.

1) Published Market Prices :
Published market prices can be used to establish transfer prices. But these prices should be prices actually paid in the marketplace. In the same way, the conditions that exist in the outside market should be consistent with those that exist within the company.

2) Bids :
Market prices may be set by bids. Low bidders stand a reasonable chance of getting the business. Transfer prices can be set by such bids.

3) Sale By Production Profit Centre :
If the production profit centre sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price. For example, if a manufacturing profit centre normally earns a 10 percent profit over standard cost on the products that it sells to outside markets, it can replicate a competitive price by adding 10 percent to the standard cost of its proprietary products.

4) Purchase by Buying Profit Centre :
If the buying profit centre purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products. This can be done by calculating the cost of the difference in design and other conditions of sale between the competitive products and the proprietary products.

B) Cost - Based Transfer Prices :
If competitive prices are not available, transfer prices may be set on the basis of cost plus a profit. Two decisions must be made in a cost-based transfer price system. They are :

a) Decisions Made in Cost-based Transfer Price :

i) How to Define Cost :
The usual basis is standard costs. In this method, actual costs should not be used because production inefficiencies will be passed on to the buying profit centre. If standard costs are used, an incentive is needed to set tight standards and improve standards.

ii) How to Calculate the Profit Mark-up :
Two decisions are to be taken in calculating the profit mark-up. They are :
a) What the profit mark-up is based on
b) The level of profit allowed.
To calculate this, a percentage of cost is the simplest and the most widely used base. If it is used, no account is taken of capital required. A conceptually better base is a percentage of investment.

b) Problem Areas :

Problem areas when using costs as a basis for transfer pricing could be broadly covered under materials and labour and overheads. They are given below:

1) Materials :
  • Purchase costs could vary from consignment to consignment.
  • One could dispute the percentage to be added on account of manufacturing losses.
  • One has to decide if abnormal losses have to be provided.
  • Control prices v/s market prices.
  • FIFO, LIFO, average or derived from specific consignment.

2) Labour and Overheads :
The following are areas which could lead to disputes :
  • Level of activity to be adopted.
  • Efficiency variables
  • Abnormal items
  • Basis of overhead allocations
  • Expenditure incurred to derive long term benefits.
  • Varying capacity utilization each year and impact thereof on overhead allocation.
  • Share of R and D and corporate office expenses.

C) Two Step Pricing :
Another method of transfer pricing is to establish a transfer price that includes two charges. They are as follows:
a) For each unit sold, a charge is made that is equal to the standard variable cost of production.
b) A periodic charge is made that is equal to the fixed costs associated with the facilities reserved for the buying unit.
One or both of these components should include a profit margin. 
For example, assume the conditions given in the following illustration.

Business Unit A (Manufacturer)

Product X

Expected Monthly Sales to Business Unit B

Variable Cost Per Unit

Monthly Fixed Costs Assigned to Product

Investment in Working Capital and Facilities

Competitive Return on Investment Per Year

5000 units

Rs. 5

20,000

12,00,000o

 10%


One way to transfer product X to Business unit B is at a price per unit, calculate
as follows.



Transfer Price for Product X

Variable Cost Per Unit

Plus Fixed Cost Per Unit

Plus Profit Per Unit

Transfer Price Per Unit

Rs. 5

4

2

Rs. 11


Plus Profit Per Unit 10% of monthly investment per unit =
(12,00,000/12)
------------------- X 0.10
5,000
= 2.00

In this method, the transfer price of Rs. 11 per unit is a variable cost so far as unit B is concerned. However, the company's variable cost for product X is Rs. 5 per unit. Thus, unit B does not have the right information to make appropriate short term,marketing decisions. If unit B knew the company's variable costs, it could safely take business at less than its normal price under certain conditions.
Two step pricing corrects this problem by transferring variable cost on a per unit basis and transferring fixed cost and profit on a lump-sum basis. Under this method, the transfer price for product X would be Rs. 5 for each unit that Unit B purchases, plus Rs. 20,000 per month for fixed cost, plus Rs. 10,000 per month for profit.
It means
12,00,000
------------------ x 0.10
12
If transfers of product X in a certain month are at the expected amount of 5,000 units, under this method, Unit B will pay the variable cost of Rs. 25,000 (5000 units x Rs. 5 per unit), plus KS. 30,000 Tor fixed costs and profit a total of Rs. 55.000, This is the same amount it would pay Unit A if the transfer prices were Rs. 11 per unit (5000 x 11 = 55000).
The fixed cost calculation in the two-step pricing method is based on the capacity reserved for the production of product X that is sold to Unit B. The investment represented by this capacity is allocated to product A. The return on investment that unit A earns on competitive products is calculated and multiplied by the investment assigned to the product.

D) Dual Price :
In this method, the manufacturing unit's revenue is credited at the outside sales price and the buying unit is charged the total standard costs. The difference is charged to a headquarters account. It can be eliminated at the time of consolidation of statements of the business unit. This transfer pricing method is
sometimes used when there are frequent conflicts between the buying and the selling units that cannot be resolved by one of the other methods. Both the buying and selling units benefit under this method. This method gives full autonomy to both the divisions. No interference is made by any of them in each other's activities.

a) Disadvantages :

1) Shows Greater Profit of Units than the Company :
The main problem in this method is that sum of profits of all business units will be greater than the overall company's profit. Senior management must be aware of this situation when approving budgets for the business units and subsequently evaluating performance against these budgets.

2) Shows False Picture of Profit :
This system creates an illusory feeling that business units are making profits while in fact company may be in losses because of debits to headquarters.

3) Motivates to Concentrate on internal Transfers :
This system might motivate business units to concentrate more on internal transfers where they are assured of a good markup at the expense of outside sales.

4) Additional Book Keeping :
There is additional book keeping involved in first debiting the headquarters account every time a transfer is made and then eliminating this account when business unit statements are consolidated.

E) Profit Sharing :
If the two step pricing method is not feasible, a profit sharing method can be used. It ensures congruence between business unit and company interest.

This system operates as follows :
i) The product is transferred to the marketing unit at standard variable cost.
ii) After the product is sold, the business units share the contribution earned, which is the selling price minus the variable manufacturing and marketing costs.
This method is suitable if demand for the manufacturing division's product is not steady. It tries to keep consistency in goals with final division and that of company.

a) Problems :

Implementing such a profit sharing system produces several practical problems. They are as follows :

1) Problem of Division of Contribution :
There can be arguments over the way contribution is divided between the two profit centres. Senior management might have to intervene to settle these disputes. This is costly and time consuming. It works against a basic reason for decentralization i.e. autonomy of business unit managers.

2) Reliability of Information :
Arbitrarily dividing up the profits between units does not give valid information on the profitability of each unit.

3) Problem of Evaluation :
The basis for sharing the profit may be vague and may not lead to correct evaluation of performance. In the same way, performance of one unit depends on another unit's ability.

Administration of Transfer Prices :


Most transfer price systems require formal administration procedures to operate successfully. They are explained below :

1) Negotiation Among Divisions :
In most companies, transfer prices are not set by a central staff group but they are negotiated between the divisions. The reason is that it is believed that establishing selling price is the important function of line management. If this function is assigned to the headquarters staff, line management's ability to affect profitability is reduced. Also, many transfer prices require a degree of subjective judgement. Many transfer prices are results of compromise positions by both buyer and seller. If transfer prices are established by the headquarters, business unit managers may argue that their low profits are due to the arbitrariness of the transfer prices.
There must be some rules in respect of transfer price negotiations. in the same way, business units must know these prices because they have to negotiate prices. 
In a few companies, headquarters inform business units that they are free to deal with each other or with outsiders as they deem fit. If this is done and there are outside sources and outside markets, no further administration procedures are required. The market sets the prices and if the divisions are not agree on a price they buy from or sell to outsiders. In many companies, the divisions are required to deal with each other. If they do not have the threat of doing business with competitors as a bargaining point in the negotiation process headquarters staff must develop a set of rules that govern both pricing and sourcing of intra-company products.

2) Sourcing and Transfer Pricing Rules :
The sourcing and transfer pricing rules depend on the number of intra-company transfers and the availability of markets and market prices. If they are in greater numbers, there must be more formal and specific rules. If market prices ans readily available, sourcing can be controlled by having headquarters review make or-buy decisions that affect revenues in excess of a specified amount. If the market prices are not available and there are number of intra-company transfers, following guidelines can be followed :

a) Classification of Products :
Products can be classified into two main clauses as follows :

i) Class I :
This class includes all products for which senior management wishes to control sourcing. Such products may be large-volume products, products for which there is no outside source in existence. These products are products over whose manufacturing senior management wishes to maintain control for the reason of quality or secrecy.

ii) Class II:
This class includes all other products. In general, these are products that can be produced outside the company without any significant disruption to present operations. These products are of relatively small volume. These are products which are produced with general-purpose equipment Class ll products are transferred at market prices.

b) Determination Sourcing :
The sourcing of class I products can be changed only by permission of central management. The sourcing of class ll products is determined by the business units involved. Both the buying and the selling units are free to deal either inside or outside the company.
Under this arrangement, it becomes possible for the management to concentrate on the sourcing and pricing of a relatively small number of high-volume products.

3) Arbitration :
It may happen that business units are not able to agree on prices in spite of specific pricing rules. In such conditions, there may be dispute between the various divisions. So there must be some procedure for arbitrating these disputes in respect of transfer pricing.

a) Degrees of Formality :
There can be widely different degrees of formality in transfer price arbitration. At one extreme, the responsibility for arbitrating disputes is assigned to a single executive, for example, the financial vice president or the executive vice president, who talks to the division manager involved and then announces the price orally. The other extreme is to set up a committee. Usually such a committee will have following three responsibilities :
i) Settling transfer price disputes
ii) Reviewing sourcing changes
ii) Changing the transfer price rules when appropriate
The degree of formality employed depends on the extent and type of potential transfer price disputes.

b) Procedure :
Arbitration can be conducted in a number of ways. A written case is submitted to the arbitrator by both the parties. The arbitrator reviews their positions and decides on the price. In doing so, he can obtain the assistance of other staff offices.
It is important that relatively few disputes should be submitted to arbitration. If a large number of cases are submitted, it indicates the inappropriateness of the rules of transfer pricing. This is a symptom that something is wrong. Arbitration is more time consuming to both line managers and headquarters executives. It is to be noted that arbitrated prices often satisfy neither the buyer nor the seller.

Transfer Pricing Problems :


Transfer pricing problems can be explained with the examples of problems in the following fields :

1) Public Sector :
Nowadays, to earn profit is also a task of public sector industries. There is emphasis on decentralization of authority and targets. These undertakings are managed by the principle of management by objectives. The problems that are peculiar to the public sector can be given as follows :
i) Social objectives v/s profit objectives.
ii) Divisional managers do not have full control over his resources.
iii) Large turnover of divisional managers.

2) International Trade :
With liberal cash incentives available on exports and complicated tax laws, transfer pricing has special relevance in the export trade. Some of the areas that need to be looked into are as follows :
i) Utilization of spare capacity.
ii) Tax implications.
iii) Taking full advantage of various government concessions.

3) Behavioral Aspects :
The example of transfer pricing problem in behavioral aspects is in the field of accountants. Management specialists and behavioral scientists are now equally interested in the subject of transfer pricing. The reasons of problems are weak leadership, lack of relevant information and cost data and lack of confidence. There could be no formal or informal agency to resolve conflict situations and where it is in existence, their intervention could be irregular and extent of their effectiveness doubtful. There could also be no regular review of existing transfer prices and no systematic revision.
Transfer pricing is a management tool. Its effectiveness depends on its structure and use. The divisional objectives must be clear for its smooth working. The operation manuals must be regularly revised. There must be institutionalized mechanism to resolve conflict situations. The transfer prices must be reviewed from time to time.

Illustration :

Suraj Pri. Ltd. Co. fixes the inter-divisional transfer prices for its products on the basis of cost plus a return on investment in the division. The budget for division A for 2008 - 09 appears as under :

Investment in Division 'A'

Rs.

Rs.

Fixed Assets

6,00,000

5,00,000

Current Assets

3,50,000

3,00,000

Debtors

2,50,000

2,00,000

Annual Fixed cost of the Division

9,00,000

8,00,000

Variable cost per Unit of Product

 

10

Budgeted volume - 4,00,000 units per year

 

 

Desired ROI 28%

 

 

 Determine the transfer price for Division 'A.


Solution :

Investment in Division

Rs.

Fixed Assets, Current Assets and Debtors

12,00,000

Desired return on investment (ROI) 28% on 12,00,000

3,36,00

Variable Cost 4,00,000 x 10

40,00,000

Annual Fixed Cost of the Division. A

9,00,000

Total Cost

49,00,000

Add : Return on Investment

3,36,000

 

52,36,000

Inter-divisional Transfer Price = 

52,36,000
-------------- = Rs. 1.309 per unit.
40,00,000 

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