TRANSFER PRICING

A transfer price is defined as “the price that is assumed to have been charged by one part of a company for products and services it provides to another part of the same company, in order to calculate each division's profit and loss separately.” cing

OBJECTIVES OF TRANSFER PRICING

The main objective of transfer pricing is proper distribution of revenue between profit centers. If two or more profit centers are jointly responsible for product development and marketing, then the resulting profit has to be shared between the profit centers. Some other objectives of transfer pricing are:

• Providing relevant information to the profit centers regarding the trade-off between costs and revenues of the company.• Inducing goal-congruent decisions, i.e., decisions that improve the profits of business units and also improve the profits of the company (this is discussed in detail below).• Helping to measure the economic performance of profit centers.• Minimizing tax liability.

PRINCIPLE OF TRANSFER PRICINGThe 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”.2

Goal CongruenceWhile designing the mechanism for transfer pricing, the interests of profit centers should neither supersede the interests of the overall organization, nor should there be a clash of interests between the organization and its profit centers. In other words, there should be goal congruency between profit centers and parent organization. Some of the prerequisites for achieving goal congruency are:Transfer Pricing• Competent people• Good organizational atmosphere• Details of market prices• Freedom to source• Availability of information• Scope for negotiation

Competent peopleOrganizations need managers who can balance long-term and short-term goals. Managers are often accused of sacrificing long-term gains for short term profits. This approach can prove disastrous for the organization. Transfer pricing can be misused for manipulating profits, and this gives a wrong pictureof the position of the company. Hence, organizations should have competent people skilled at negotiation and arbitration, who are capable of determining the appropriate transfer prices. This makes goal congruency possible.

Good atmosphereIn order to achieve goal congruency, managers of profit centers, especially the buying profit centers, should ensure that the transfer prices charged by the selling profit centers are just. This will create an atmosphere of trust between selling profit center and buying profit centers.

Details of market pricesWhen a product is transferred from one profit center to another, the normal market price for the identical product can be taken as the basis for establishing the transfer price. The market price should reflect the same conditions in terms of quantity, quality, time for delivery, etc. as characterize the product to whichthe transfer price applies. The market price can be adjusted to reflect savings due to lower expenses on advertising and marketing as the product is sold within the company.

Freedom to sourceManagers of selling profit centers should be given freedom to sell their goods in the external market, while managers of buying profit centers should be allowed to buy their goods from the external market. Thus the market becomes the main determinant of the transfer price.

Availability of informationManagers should be fully aware of market conditions and should have all the necessary information available to them, before they take any decision. For example, managers should be aware of the alternatives available and the relevant costs of and revenues derivable from each alternative.

Scope for negotiationThere must be a mechanism for negotiating contracts, and managers who take transfer pricing decisions should be trained in negotiation.

If all the above conditions are met, then companies can devise a mechanism for transfer pricing based on the market price. But quite often these conditions are not fulfilled, and it becomes difficult to achieve goal congruency. Some situations that are not favorable for achieving goal congruency are:• Limited markets• Excess or shortage of capacity in the industryLimited marketsMarkets for buying and selling the goods of the profit centers may be either very small or nonexistent. Some of the reasons for this are: Firstly, the profit center may have spare internal capacity, but may not wish to make any external sales. Secondly, if the company is the sole producer of a differentiated product then outside capacity does not exist. Thirdly, a company that has invested heavily in facilities will not want to source goods fromoutside unless the selling price in the market is as low as its own variable cost.Excess or shortage of industry capacityThere may be situation of excess capacity or shortage of capacity in the industry. The selling profit center does not sell in the outside market when there is excess capacity in the industry. The buying profit center may purchase from outside vendors even though there is capacity available inside the company. Thus the company, as a whole, may not be optimizing its profits. In a situation of insufficient capacity in the industry, the buying profit center may be unable to obtain products it needs from the external market, whereas the selling profit center is able to make profits by selling the product in the external market. This situation occurs when demand is high and industry capacity is low. Here also, the company, as a whole, may not be able to optimize profits.

Sourcing constraintsWhen there is an excess or shortage of industrial capacity, the sourcing decisions taken by the company are vital. A company may allow its buying profit center to buy goods from outside, if the profit center is getting a better deal in terms of quality, price and service. In the same way, a selling profit center may be allowed to sell its products in the open market if it gets a better profit by selling in the market. Whatever be the case, the management should not get bogged down by pressures within the company and should try to take decisions that optimize the profit of the company.

METHODS OF CALCULATING TRANSFER PRICE

Methods used for calculating the transfer price differ from company to company. Companies should evaluate all the methods before adopting one that is most suitable for them. The following criteria should be used to evaluate the methods for calculating transfer price.

Goal congruence: As already discussed, transfer prices should balance between goals of enterprise as a whole and its profit centers.

Rationality: Transfer prices should not interfere with the process by which the buying center manager rationally strives to minimize costs and the selling center manager rationally strives to maximize revenues.

Autonomy: Each profit center manager should be free to satisfy his center’s needs either internally or externally at the best possible price.

Performance evaluation: Transfer pricing should aid in objective evaluation of the activities of the profit center. It should be used as a tool for making proper decisions. It should also aid in appraisal of managerial performance and of the enterprise as a whole.

The three methods of calculating transfer price that are used commonly are:• Market-based pricing method• Cost-based pricing method• Negotiated pricing method

Market-Based Pricing MethodCompanies that use this method price the goods and services they transfer between their profit centers at a price equal to that prevailing for those goods and services in the open market. This is similar to ‘arm’s length’ pricing as intra company transfers are priced the same as those for external customers.

Market-based pricing method has two main advantages for a company.

Firstly, business units can operate as independent profit centers with the managers of these units being responsible for their own performance as well as that of the business unit. When managers are made responsible for performance of the business unit, it increases their motivation and it also becomes easier for the headquarters to assess the actual operating performance of its business units.

Secondly, tax and customs authorities favor the market price method because it is more transparent and they can crosscheck the price details provided by the company by comparing them with market prices on that date.

In practice, however, the use of a market price as a benchmark is difficult because often there is no competitive market which can provide a comparable price. For some types of complex capital equipment, an external market may not exist at all. In some cases, prices may be distorted by monopoly elements.Moreover, a definitive market price may be difficult to determine because of variance in prices from one market to another due to changes in exchange rates, transportation costs, local taxes and tariffs etc. In addition, a company may set its selling price depending on the supply and demand conditionsprevalent in a specific market. In sum, these factors mean that a unique market price for companies to follow does not always exist.

Cost-Based Pricing MethodThe cost-based pricing method calculates transfer price on the basis of the cost of a good or service. The cost of a good or service is available in the cost accounting records of the company. This method is generally accepted by the tax and customs authorities since it provides some indication that the transferprice approximates the real cost of item. Cost-based approaches are, however, not as transparent as they may appear. A company can easily manipulate its cost accounts to alter the magnitude of the transfer price.Companies that adopt the cost-based transfer pricing method have to choose between alternative approaches, which are listed below:• Actual costs approach• Standard costs approach• Variable costs approach• Marginal costs approach

Apart from this, companies also have to decide on the treatment of fixed costs, and research and development costs. These issues can prove problematic for the company that adopts a cost-based transfer pricing method. Cost-based methods usually create difficulties for the selling profit center, as theirincentive to be cost-effective may fall, if they know that they can recover increased costs simply by raising the transfer price. Without an incentive to produce efficiently, the transfer price may erode the competitiveness of thefinal product in the market place.

Negotiated Pricing MethodIn this approach, buying and selling business units freely negotiate a mutually acceptable transfer price. Since each unit is responsible for its own performance, this will encourage cost minimization and encourage the parties to seek a transfer price which yields them an appropriate profit return.However the tax authorities have their reservations about this method because companies that use this method have greater scope of manipulating transfer prices, to minimize their tax liability.

UPSTREAM FIXED COSTS AND PROFITSA typical transfer pricing problem is encountered in oil companies, paper companies and other integrated companies in which raw material is extracted and processed further for production of the final product. In such companies, in the absence of proper transfer pricing, the division that sells the final product to outside customers may not be aware of the fixed costs involved in the internal purchase price. For example, an oil company has three divisions: the crude oil division, the refinery division and the sales division. The final product of the company, say petroleum, is sold by the sales division, but before this, the crude oil division sells its crude to the refinery division, from where it is sent to the sales division. In this situation, the sales division may underestimate the costs (particularly the fixed costs) incurred duringextraction and processing. So, it might sell the final product at a price that is not sufficient to recover fixed costs. Due to this company may incur losses and there can be a conflict between the two divisions.

In order to tackle these kind of problems, companies should adopt followingmethods.• Two step pricing• Profit sharing• Two sets of pricesTransfer PricingTwo Step PricingTwo step pricing involves charging for the product being transferred twice. First, the product is priced on the basis of the variable cost incurred in producing it. At the second stage of pricing, the fixed costs that are incurred because of certain special facilities used for production are also included. Thesum of these two charges constitutes the transfer price for the product.

Profit SharingUnder this method, the product is transferred to the marketing unit at the standard variable cost. After the product is finally sold, the business units share the profit earned. But, this method may lead to disagreements over the way the profit is divided between the two profit centers. Sometimes, seniormanagement has to intervene to settle these disputes. As the profits between units are divided arbitrarily, it does not reflect accurately the profitability of each segment. Also, as the manufacturing unit's contribution depends on the marketing unit's ability to sell and the actual selling price, this may be treatedas unfair by the manufacturing unit.

Two Sets of PricesUnder this method, revenue is credited to the manufacturing unit at the market sales price and the buying unit is charged for the total standard costs. The difference between the outside sales price and the standard cost is charged to the parent company’s account. These charges are later eliminated while drawing consolidated financial statements. This method is used when there are frequent conflicts between the buying and selling units and they cannot be resolved by any method.The disadvantages of this method are:1. It is difficult to maintain an additional book each time a transfer of good is made.2. It motivates the managers to concentrate only on internal transfers (where they are assured of a good markup) at the expense of outside sales.

ADMINISTRATION OF TRANSFER PRICESImplementing transfer pricing involves long negotiations between heads of various units, classification of products, and arbitration and conflict resolution in case conflicts arise.

NegotiationBusiness units of companies negotiate among themselves before taking decisions pertaining to transfer prices. The headquarters does not involve itself in formulating transfer prices and leaves it to the line managers of the respective units to establish the buying and selling prices. There are two reasons for this. Firstly, the line managers of the business units may feel powerless if they are denied any say in the transfer prices, and this may affect their motivation. Secondly, if the profits of business units are poor then the unit managers may argue that it is due the arbitrariness in setting transfer prices by the headquarters.

Arbitration and Conflict ResolutionThere may be times when business units are not be able to reach an agreement on transfer price easily. In such situations, business units should follow a set procedure for arbitrating disputes relating to transfer price. The responsibility for arbitration rests with the parent company. It may assign a single executivewho can talk to the business unit managers and arrive at an agreement over the price. Alternatively, a committee may be formed with the following responsibilities: to settle transfer price disputes, to review sourcing changes, and to change the transfer price rules whenever necessary.Organizations can have a formal or informal system of arbitration to administer the transfer price mechanism and to resolve the conflicts. In a formal system of arbitration, both the parties submit a written case to the arbitrator, who reviews it and decides the price. In an informal system of arbitration, most of the presentations are oral. Irrespective of the formality of the arbitration and the process of conflictresolution in an organization, the goal is to make the system of transfer pricing system effective. The management can use any one of the following ways to resolve the conflicts: forcing, smoothing, bargaining, and problem solving. Forcing and smoothing reflect conflict avoidance, whereas bargaining and problem solving indicate conflict resolution.

Product ClassificationSourcing and transfer pricing are greatly affected by the number of intracompany transfers and the availability of markets and market prices. The larger the number of intracompany transfers and the less the availability of market prices, the greater the need for more formal transfer pricing rules. If market prices are readily available, the headquarters can play a vital role in making sourcing decisions. In some companies, products are classified into various categories to help in determining transfer prices. For example, a company can divide its product portfolio into two classes before taking transfer pricing decisions.Class I products may include all those products whose transfer price the senior management at the headquarters would like to control.Class II products may include those products that can be produced outside the company without disrupting the normal workflow. These products are small in volume and are transferred at market prices.