Presented By:-Group 9

TRANSFER PRICING

Transfer price is the price which one unit of the organization charges for a product or service supplied to another sub-unit of the same organization. The issue of transfer pricing becomes important when accounting is to be used for the purpose of divisional performance measurement. The transfer price used in the organization will have significant effect on the financial performance of different divisions. Transfer pricing has a significant bearing on the revenues, costs and profits of responsibility centres.

Objectives Any transfer pricing system should aim to: (i) Ensure that resources are allocated in an

optimal manner.

(ii) Promote goal congruence. (iii) Motivate divisional managers. (iv) Facilitate the assessment of

management performance.

(v) Retain divisional autonomy.

Requirements of Transfer Price  (i) Transfer price should be objectively

determinable. (ii) It should be equal to the value of the

intermediate products being transferred. The transfer price should compensate the transferring division and charge the buying division for the value of the product exchanged.

(iii) It should be compatible with the policy that maximizes attainment of a company's goals and evaluation of segment performance.

Although different approaches will result in different figures of transfer price, the limits within which the transfer price should fall are:

Minimum: The sum of selling division's marginal cost and the opportunity cost of resources used.

Maximum: The lowest market price at which the buying division could acquire the goods or services externally, less any internal cost savings in packaging and delivery.

  The difference between the two limits

represents the savings made by producing internally as opposed to buying it from outside.

 

Methods of Fixing Transfer Prices Transfer pricing methods are broadly classified

into three categories: (a) Cost based prices (b) Market based prices (c) Negotiated prices Cost Based Methods (i) Cost Price In this method, goods or services are transferred

at their actual cost of production. This method is the simplest of all the methods used. It is useful for those units where the responsibility of profit performance is centralized. Under this method, it is difficult to measure the performance of each profit centre. The selling division does not earn any profit and the purchasing department's profit is inflated.

(ii) Standard Cost Under this method, all transfers are valued at

standard cost. The supplying division normally absorbs variances from standard cost. In certain cases variances from standard cost are transferred to the user division and, therefore, both the supplying and receiving divisions carry inventories at standard cost . Once the standards are properly set, operation of this system is simple. However, the responsibility of profit performance is centralized. Profit performance of each division cannot be measured.

(iii)Cost Plus a Normal Mark-up Under this method, the transfer price includes,

besides unit cost of production, some profit margin or normal mark-up. The price received/ paid by the selling and purchasing department respectively includes an element of profit. The mark-up can be determined in two ways. It is either a target profit fixed by the management or a profit margin equal to that, which competing organizations may reasonably be expected to realize. When the second basis is adopted, the transfer price approximates the market price.

Depending upon its closeness to the real market value, it may be useful for the profit centre analysis. But in case of a target profit, it may not be so.

 

(iv) Incremental Cost When the entire production of the selling

division is transferred internally and there are no outside customers, incremental cost includes all variable cost plus any fixed costs directly attributable to internal transfer. Such a transfer price is not appropriate for measurement of divisional performance.

When there are outside customers for the goods and the division is not able to produce the full demand (from the outside customers as well as sister divisions), the incremental cost to the selling division would be the revenue lost on sales to outside customers i.e. the market price. Such a cost is useful for profit centre analysis.

Market Price Based Methods The market price can be arrived at in three ways: (i) Through prevailing market price if there is an active market for

goods and services transferred between divisions. The prevailing

price is adjusted for discounts and selling costs, which are not involved in inter- divisional exchange. This method has the following merits:

(a) market prices represent alternatives to the division.That is market price will be the basis, if the selling division sells the goods to the outside customers and the buying division purchases from outside suppliers.

(b) market prices are neither arbitrary nor artificial. They reflect the collective values of buyers and sellers. Such a transfer price gives the following advantages to the selling division:

-         no risk of bad debt -         no direct promotional expenses.

The buying department will have the advantages of assured delivery schedule and full customer service. Therefore, where divisions have the alternative to buy from/sell to the open market, they would prefer to buy from or sell to the sister division.

(ii) Where easily identified market prices are not available, costs plus a normal profit provides a reasonable approximation of the market price.

(iii) Where the market price is not available, bids are invited from different manufacturers and the lowest bid is taken as the market price and used for internal transfer pricing. The limitation of this method is that the bidders may either tender spurious bids or may not bid at all, knowing that the firm does not intend to buy goods but intends to use the bid for internal purposes.

Negotiated Prices The inter-divisional transfer price can also be

based on a price mutually agreed upon by the buying and selling divisions through negotiations. The advantage of this method is that it will lead to a transfer price, which is mutually advantageous to both the divisions and the organization as a whole. This method, however, can be applied only in those situations in which the selling division has the choice of customers and the purchasing division has choice of suppliers.

Dual (Two-way) Prices Under this method of transfer pricing, the transferring

division is credited with one price and the acquiring division is charged at a different price. This method eliminates the possibility of conflict caused by a single transfer price in which case one segment receives relatively less contribution of profit because the price setting process entitles the other segment to receive relatively more.

The price to be charged to the acquiring division should be based on what it costs the firm as a whole to produce and distribute the intermediate product under normal conditions. The appropriate cost should be the incremental cost in non-recurring situations and full standard cost for long run continuous situations. These prices reflect effective cost of resources consumed by the firm and the segment. For this reason, this is an appropriate basis for evaluating the performance of the user of the resources. At the same time, the transferring division receives the market price for intermediate products or a negotiated price based on the market price of the final product.

Comparison of Different Transfer Pricing Methods Criteria Market Price Based

Methods Cost Based Methods Negotiated Price

Method Achieve goal congruence

Yes, when the markets are competitive

Often, but not always

Yes

Useful for evaluating unit performance

Yes, when the markets are competitive

Difficult, unless transfer price exceeds full cost

Yes, but transfer prices are affected by bargaining strength of divisions

Motivate management effort

Yes Yes, when based on budgeted costs. Less incentive to control costs if transfers are based on actual costs

Yes

Preserves sub-unit autonomy

Yes, when the markets are competitive

No, because it is rule based

Yes

Other factors No market may exist or markets may be imperfect or in distress

Useful for determining full cost of products and services, easy to implement

Bargaining and negotiation take time. Price may need to be revised repeatedly as conditions change.

There is no method, which meets all the criteria. The transfer price a company will eventually choose depends on the economic circumstances and the decision at hand.

General Guideline for Transfer Pricing The following general guideline (formula) is a

helpful first step in setting a minimum transfer price in many situations.

Minimum Transfer Price = Additional outlay cost per unit incurred because goods are transferred +Opportunity cost per unit to the organization because of the transfer

Additional outlay cost in this context means the additional cost of producing and transferring the products or services. Opportunity cost here is the maximum contribution margin foregone by the selling sub-unit, if the products or services are transferred internally.

When the selling sub-unit is operating at capacity, the opportunity cost of transferring a unit internally rather than selling it externally is equal to the market price minus variable cost of marketing. The opportunity cost is zero when the selling sub-unit has an idle capacity. When no market exists for the intermediate product, any price between the incremental cost and the market price can be fixed.

The units should indulge in inter-unit transfer rather than buy outside to minimize cash outflow for the company. One unit should not profit, if its action reduces the utilization of capacity of another unit. For example, a transferee unit may prefer to buy from outside though the other unit has the capacity to supply the same. In such a case, the overall profit of the company will be sub-optimal.