Definition of Transfer Pricing

Introduction

Generally, the companies have various divisions or departments with profit and investment centres and the goods are being transferred from one division to another. The profit may be added with cost of goods while transfer takes place. The price on the goods of intra- company transfer from is known as transfer pricing. In this chapter we shall understand the concept of transfer pricing and other related issues.

Transfer Pricing Definition

Transfer price is a notional value at which goods and services are transferred between divisions in a decentralized organization. The prices are set for intermediate products, which are goods, and services that are supplied by the selling division to the buying division. The goods that are received by the buying division may be processed further and before being sold to outside world as final products. We can ask why these kinds of transfers occur within the organization. This is because of the finished goods of one division becomes the raw material of another division.

For example, we can take textile Industry; it involves variousprocesses for getting the final product which is used by the ultimate consumer. The processes are spinning, doubling, dying, weaving, printing, garments and designing. The finished product of each division becomes the input of the next division. Therefore, the output of each division must be transferred to another. A notional profit may be added with cost price while transfer takes place for the purpose of accounting and measuring the performance of each division, because each division has responsibility centers such as profit and investment.

The price charged for the inter-departmental transfers is revenue to the selling division and cost to the buying division. That is why the concept of transfer pricing is a technique of strategic decision. The transfer price charged on goods transferred affects the profits of both transferor and transferee division. The benefit earned by one division becomes the cost of other division. However, the selling division may charge higher prices for the goods transferred due to show higher profit. It affects the buying division because cost of input become high due to the higher profit is added to the price paid by them. But the overall profitability of the organization remains unaffected.

Objectives of Transfer Prices

A sound transfer price system should accomplish the following objectives:

Divisional autonomy

Divisional performance appraisal

Goal congruence

Divisional Autonomy

The division manager must take sound decisions to show their divisions’ efficiency through its responsibility centers, a sound transfer pricing system act as a motivational force and it serves the effective communication for such decision. This can happen when the division manager takes the action to improve the reported profit of his division and it improves the profit of the company as a whole.

Divisional Performance Apprasial

Profit is the yardstick for measuring the performance. Transfer pricing facilitates to measure the divisional performance.

Goal Congruence

The division manager’s goal must be positively correlated with the goal of organization as a whole. The decisions taken by the divisional managers for increasing their divisional profit should not affect the profits of the other divisions. The transfer pricing system must serve as a motivational force to the division managers and at the same time it should not go to the beyond level at which injures the goal of entire organization.

Usefulness of Transfer Pricing

The concept of transfer pricing is used:-

To identify unit contribution to the total profit,To encourage profit consciousness,

To Measure management performance,

To Maximize operating unit profitability,

To Locate profits to minimize tax,

To Facilitate decentralized decision making,

To Motivate divisional managers, towards goal congruence, and

To serve as a tool for control.

The disadvantages of transfer pricing

Divisional managers may try to achieve the divisional profits rather than corporate profit,

It creates confusion on the price of the final product due to the lengthy disagreements on prices,

It may be incurred an additional administrative costs,

Arguments over disposition of variances,

Task of eliminating book profits arising from interdivisional profits.

Organisational Framework

There is various method of arriving transfer prices; the right method is used under the right conditions, but there is no single method ideal in all situations. The organizational situation may differ from one firm to another, it is mainly depends upon the nature of industry, organization structure, its culture, degree of centralization etc.

The following factors are to be considered when developing procedure for determining transfer prices:-

The role of the corporate office when the prices are centrally administered,

The degree of internal bargains,

Accountants’ role, and

Whether the prices are to be related to costs or resulting from selling prices.

The company’s organizational structure is very important factor which is to be considered on the following grounds:-

Nature of industry and size of operations,

Extent of vertical and lateral integration,

Extent of decentralization, and

Objectives before the management.

Other significant aspects that need to be considered are

Sourcing decisions

Manufacturing processes

Market situation

Control Exercised by the centre can include certain areas

Sourcing Decisions

Whether the divisions of buying and selling can take sourcing decisions by themselves or some other divisions can take such decisions.

Manufacturing Processes

Mass, batch or unit,

For stock or against specific orders, and

Whether raw material, intermediate or and products.

Market Situation

Buyer’s vs. seller’s market,

Extent and nature of competition.

Control Exercised by the centre can include the following areas

Sourcing,

Pricing,

Profitability,

Return on investment,

Cost performance,

Approval of unit budget,

Cash flow,

Approval of capital expenditure,

Turnover and,

Market share.

Issues in Transfer Pricing

A rational system of transfer pricing is required to ensure profitability at each level. Ideally the decentralized profit centre is a device for measuring and evaluating performance as well as motivating divisional management to achieve corporate goals. When the company extends its operations beyond national borders, new dimensions and complications are added to the transfer- pricing problem.

The main issues to be considered for a universal example are:

Taxes and duties-local sales tax, octroi, excise duty and custom duty.

Market conditions.

Ability of the potential customers to pay for a company’s product different profit transfer rules.

Conflicting objectives of a joint venture partner.

Government regulations-local, state and central laws.

Import regulations.

Types of Transfer Pricing

Cost-based method comprising

Actual or full cost

Variable cost, and

Standard cost.

Revenue-based method comprising

Cost-Plus,

Market price, and

Negotiated price.

Hybrid or Dual pricing method.

Cost-based method comprising

Actual or full cost

Under this method, the transfer price is fixed at full cost. There is a question arise i.e., which cost should be considered? There are different types of cost such as direct cost & indirect cost, variable cost & fixed cost and cost of production & cost of sales. The adoption of cost is differing in one firm to another, based on the nature, volume and capacity of the business enterprise. Generally, the cost of sales is adopted for fixing transfer price.

We can understand from this example is that the transfer price is fixed on full cost in the division.

Variable Cost

This concept represents the additional outlay costs incurred up to the point of transfer i.e., the expenses that are directly associated with the production and transfer of the goods and services. The direct expenses are raw materials, Wages and production of the division. These expenses are varied with the volume of output. This method is very useful for overall view when there is an excess capacity in the supplying division; it leads to the purchasing division to act accordingly.

Standard Cost

The materials, labour and overheads are charged at pre-determined rates. Under this method, the costs of goods are free from fluctuations in the components of cost. The buying division is known in advance about the transfer price; hence it can plan in well advance to show the effective performance in their appraisal.

Under this system, the fixed costs are absorbed on the allocated or predetermined fixed cost. It is a drawback of this system; however, the actual efficiency would not be considered when the actual fixed costs are absorbed at a lower rate in their controlling system. This may discourage the division’s performance of cost control. That is why some companies are followed only variable costs are in estimated price or standard but actual fixed costs are absorbed in every month.

Revenue-based method comprising

Cost-plus mark-up pricing

Under this method, the cost of sale of goods is taken as usual in cost concept but here it is added with some percentage of profit. The percentage of profit is determined the Companies that follow cost-plus pricing method is taking the position that profit must be shown for any products or service at every stage of movement through the corporate system. While cost plus pricing may result in a price that is completely unrelated to competitive or demand conditions in the international markets, many exporters use this approach successfully.

Market based Transfer price

A market based transfer price is derived from the price required to be competitive in the market. Under this method the goods are transferred between divisions on open market prices, which possesses the advantage for optimal decisions without any constrains. The divisions can get the status of sovereignty and it facilitates to achieve the maximum profitability of both divisions and the organization as whole.

Negotiated price

Negotiated price is the price of mutual bargain between the buying and selling divisions for transferring goods or services. The purchase division may or may not accept the deal and it may obtain outside bids and negotiate with external suppliers.

The negotiated price is suitable under the following circumstances:-

The negotiators must share the market information.

The full support and involvement of the top management is essential.

The external market should be existed.

There should be a freedom of external buying and selling for both divisions.

The market information must be available.

Drawbacks of the negotiated pricing method:-

The negotiation process makes time delay and the unnecessary effort while transferring the goods.

It creates the problem of conflict among the divisions.

The final result is based on the managers’ negotiation skill.

The cooperation among the divisions may disrupt due to conflict among the divisions.

The principle of decentralization is affected when the top management compromising the divisions.

Dual Rate Method

The dual pricing strategy overcomes the problems between buying and selling division of marginal cost. That is the selling division is credited with a price based on the total cost plus mark-up and the buying division is debited with marginal cost. This may lead to some difference between the two prices and the difference is transferred to the Transfer Price Adjustment Account. This account is adjusted with the profits of two divisions to show the correct profit for the organization as a whole.

Drawbacks of the Dual Rate method:-

This method is not suitable when multi-variety of goods or services are being transferred to different divisions.

The principle of decentralization is affected because the head office has to maintain the Transfer Price Adjustment Account.

Both buying and selling divisions cannot get high incentives because of non-monitoring the performance.