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Transfer Pricing

The document discusses various methods for setting transfer prices between different divisions or profit centers within a company. It describes transfer pricing as the price charged for goods and services transferred internally. The objectives of transfer pricing include properly distributing revenue among divisions and measuring division performance. Common transfer pricing methods discussed are based on market price, marginal cost, full cost, negotiated prices, and dual pricing.

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514 views35 pages

Transfer Pricing

The document discusses various methods for setting transfer prices between different divisions or profit centers within a company. It describes transfer pricing as the price charged for goods and services transferred internally. The objectives of transfer pricing include properly distributing revenue among divisions and measuring division performance. Common transfer pricing methods discussed are based on market price, marginal cost, full cost, negotiated prices, and dual pricing.

Uploaded by

siva
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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MANAGEMENT CONTROL SYSTEMS

eMEP 10/ ePGP 03 CA K.P.Rajendran

Transfer Pricing
What is a transfer price? Purpose of Transfer Pricing Objectives of Transfer Pricing Transfer Pricing Decisions Transfer Pricing Principles Transfer Pricing Rules Different Methods of Transfer Pricing

Transfer Pricing
For organizations that practice decentralization, one of the principal challenges is to devise a satisfactory transfer pricing system.

What is a Transfer Price?


Transfer price is the price that a profit center charges another profit center for the goods and services transferred by it.

Purpose of Transfer Pricing


When two or more profit centers are jointly responsible for product development, manufacturing, and marketing, each should share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue.

Purpose of Transfer Pricing


One of the principal reason for the transfer pricing system is to create a performance measurement system which would ensure goal congruence. Another goal is to provide autonomy to profit centers which would ensure effective decentralization.

Objectives of Transfer Prices


The main objective of transfer pricing is to ensure proper distribution of revenue among profit centers and to provide a means for measuring the economic performance of a business unit.

Transfer Pricing Principles


The fundamental principle of transfer pricing 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.

Transfer Pricing Rules


But how these outside selling prices are determined? For this the following general rule may be applied: Transfer price = Outlay Cost + Opportunity Cost

Outlay Cost
Outlay cost is the additional amount the selling business unit must incur to produce and transfer a product or service to another business unit. It is often the variable cost for producing the item transferred.

Opportunity Cost
Opportunity cost is the maximum contribution that the selling unit forgoes by transferring the item internally.

Transfer Pricing Rules


Two situations may arise:
The business unit operating at full capacity and The business unit operating at less than the full capacity.

Transfer Pricing Rules


Full capacity: When the selling division is operating at full capacity, it must forego external sales in order to sell to another division. In such a situation, the transfer price is the outlay cost for the division, which is normally the variable cost, plus the opportunity cost, which is the contribution the division foregoes on the external sale.

Transfer Pricing Rules


This is nothing but the market price of the product.

Transfer Pricing Rules


Under capacity: The second consideration arises when the selling division operates at less than full capacity. Under this consideration, the transfer price would be the outlay cost which is normally the variable cost.

Transfer Pricing Rules


This is because the opportunity cost, which is the contribution margin the unit could have obtained for the external sales, is nil.

Transfer Pricing Rules


So as a general rule, the transfer price should be equal to variable cost whenever the selling division is operating below capacity and at market price whenever it operates at capacity.

Transfer Pricing Rules


The transfer price mechanism should also ensure goal congruence, that is, any decision to improve business unit profits should also improve corporate profits.

Transfer Pricing Methods


Most corporations use any of the following transfer prices:
Transfer price based on market price Transfer price based on marginal cost Transfer price based on full cost Transfer price based on full cost plus a markup Negotiated transfer prices Dual pricing

Market-based Transfer Prices


Market based transfer prices are the best transfer prices to evaluate the performance of the profit center and to ensure goal congruence. If competitive market price exists or can be approximated for the product it should be used. If there is no way of approximating valid competitive prices, the other option is to develop cost-based transfer prices.

Market-based Transfer Prices


Companies using market-based transfer prices set the transfer price at the competitive market price for the product after making adjustments for the difference between the internal and external sales like:
Marketing and selling costs Discounts Distribution costs, etc

Market-based Transfer Prices


The market price used for internal transfers may be:
Listed price of an identical product or service The actual price the selling division charges external customers The price a competitor is offering.

Market-based Transfer Prices


Advantages:
Ensure goal congruence It is optimal for both decision making and performance evaluation It provides proper motivation to the managers.

Market-based Transfer Prices


Disadvantages:
Often there may not be a competitive market for the product

Market-based Transfer Prices


A market price-based transfer price will induce goal congruence if all following conditions exist in practice:
Competent people: Managers should be interested in the performance of their profit centers. Good atmosphere: Managers should regard profitability as an important goal and a significant measure of their performance. Existence of a competitive market price:

Cost based Transfer Prices


When the transferred goods or services do not have a well-defined market price, one of the alternatives to consider would be a transfer price based on cost.

Transfer Price based on Marginal Cost


Standard variable cost or standard direct cost of production is used as the transfer price. Advantages Optimize the profits at the corporate level Disadvantages Profits of the selling division is understated and profits of the buying division is overstated Provides a poor measure for evaluating the performance of the business unit and its the manager. Difficult to implement.

Full-Cost transfer Prices


Many companies use full-cost transfer prices Advantages:
Relatively easy to implement Will not distort the evaluation process as the selling profit center is allowed to recover the full cost of production.

Full-Cost transfer Prices


Disadvantages:
Cost of capital is not reflected Overhead allocation may be arbitrary. Does not provide an incentive for internal transfer Understate the entitys profit

Full Cost plus Markup Transfer Prices


The price is determined by adding a fixed markup to the full cost. Advantages:
Allow the selling profit center to earn a profit Provides an approximation of market price where no competitive external market price exists.

Disadvantages:
May not provide an optimal decision at the corporate level.

Negotiated Transfer Prices


This is a popular pricing alternative used by many companies. The policy can be effective if both profit centers have some bargaining power; that is, the selling profit center has some possibilities to sell its product outside the company and the buying profit center has some outside sources of supply.

Negotiated Transfer Prices


Advantages:
Open negotiation allows the managers to make optimal decisions

Disadvantages:
Negotiation of the price of a potentially large number of transactions is costly Often accentuates conflict between profit center managers Outcome often depends on the negotiation skills and bargaining power of the managers involved.

Dual Pricing
In this method, the manufacturing units 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 and eliminated when the business unit statements are consolidated.

Dual Pricing
This transfer pricing method is used when there are frequent conflicts between the buying and selling units that cannot be resolved by one of the other methods. Both the buying and selling units benefit under this method.

Dual Pricing
Advantages
Both the buying and selling units benefit under this method.

Disadvantages
The sum of the business unit profits is greater than overall profits of the company. This system might motivate business units to concentrate more on internal transfers where they are assured of a good markup at the expense of the outside sales.

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