transfer pricing - final

8/6/2019 Transfer Pricing - Final

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³Transfer Pricing´³Transfer Pricing´

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IndexIntroduction - Transfer Pricing· Objectives in Sound Transfer Pricing· General Transfer-Pricing Rule

Methods -

1. Transfers based on the External Market Price2. Cost Based

(a) Variable Cost(b) Actual Full Cost(c) Full + Profit Margin

(d) Standard Full Cost

3. Negotiated Prices4. Dual Prices

� Why MNCs use transfer pricing?



Transfer Pricingy A transfer price is that notional value at which goods &

services are transferred between divisions in a

decentralized organization.y Transfer Prices are normally set for intermediate

products which are goods & services that are suppliedby the selling division to the buying division.

yIn divisionalised companies, where profit orinvestment centers are created, there is likely to beinter-divisional transfer of goods or services and thisinternal transfer create the problem of transfer pricing.



Objectives in Sound Transfer Pricing A question arises as to how the transfer of goods & services between divisionsshould be priced. The price charged to the interdivisional transfer of goods andservices is revenues to the selling division & cost to the buying division. Thereforethe price charged will affect the profit of both divisions; benefit (revenue) to onedivision can be created only at the expense of the other division. Whiledetermining transfer prices a number of criteria (objectives) should be fulfilled.

y Transfer prices should help in the accurate measurement of divisional performance(Profitability) measurement.

y Transfer prices should motivate the divisional managers into maximizing the profitability of their divisions and making decisions that are in the best interests of the organization as a whole.

y

Transfer prices should ensure that divisional autonomy and authority is preserved. The mainpurpose of decentralization is to enable divisional managers to exercise greater autonomy and to measure the overall results achieved on profit centre or investment centre.

y Transfer prices should allow goal congruence to take place, which in effect means that theobjectives of divisional managers are compatible with the objectives of overall company.

y A transfer pricing system, if properly established, can check multinational companies and

international groups which may try to manipulate transfer prices between countries in orderto minimize the overall tax burden.



General Transfer-Pricing Rule

Managements' objective in setting a transfer price is toencourage goal congruence among the division

managers involved in the transfer.The general Rule specifies the transfer price as the sum of

two cost components.

General Rule

Transfer Price

outlay cost perunit incurredbecause goodsare transferred

Opportunity costper unit to theorganization

because of thetransfer



First component -Outlay cost

The first component is the outlay

cost incurred by the division thatproduces the goods or services to betransferred.Outlay costs will include the directvar iable costs of the product orservice and any other outlay coststhat are incurred only as a result of the transfer.

Second component Opportunity cost

The second component in the

general Transfer-pricing rule is theopportunity cost incurred by theorganization as a whole because of the transfer.

An opportunity cost is a benefit thatis forgone as a result of taking aparticular action.



IllustrationCompany Sun coast Food Centers Company

Food ProcessingDivision produces Breadin its Bakery

Gulf Division AtlanticDivision

Sells some of its productsto other companies

External Market Underdifferent Labels



Scenario 1:No Excess CapacityThe following variable costs are incurred to produce bread and transport itto buyers.

Per rack = 1 dozen bread packaged

Production:Standard variable cost per rack(including packaging)

Transportation:Standard variable cost per rack to

transport bread

Total outlay cost

Rs. 7 per rack

Rs.1 per rack

Rs.8 per rack



Suppose the Food Processing Division can sell all the bread it can produce to

outside buyers at a market price of Rs.15 per rack.Since the divisioncan sell all of its production, it has no excess capacity.

Opportunity cost:Selling price per unit in External Market

Less: Variable cost of production andTransportation

Opportunity cost (forgonecontribution margin)

Rs.15 per rack

Rs.8 per rack

Rs.7 per rack

The Opportunity Cost incurred by Suncoast Food Centers when its FoodProcessing Division Transfers a rack of bread to the Gulf Division instead of selling it in the External Market is the forgone contribution margin from thelost sale, equal To Rs.7 per rack.



General Transfer Price Rule:Outlay cost

+

Opportunity cost

Transfer Price

Rs.8

Rs. 7

Rs.15

Why does the company lose a sale in the external market for every rack of breadTransferred to the Gulf Division?The sale is lost because there is no excess capacity in the Food Processing Division.



Goal CongruenceContribution to Suncoast Food

Centers from sale in ExternalMarket

Contribution to Suncoast FoodCenters from Transfer to Gulf Division

Retail Selling

price per Rack(a loaf of breadRs.2 x Rs.12 dozen= Rs.24)Less: Variablecosts

ContributionMargin

Rs.24 per rack

Rs.8 per rack

Rs.16 per rack

Wholesale

selling price perrack

Less: Variablecosts

ContributionMargin

Rs.15 per rack

Rs. 8 per rack

Rs.7 per rack



The best use of the bakerys limited production capacity is toproduce bread for transfer to the Gulf Division.

Transfer Price Rs. 15 per rack = External Market Rs.15 per rack

[Goal congruence is maintained]

The Gulf Division manager is willing to buy the bread, because herdivision will have a contr ibution margin Rs.9 on each rack of bread

transferred .

Rs.24 retail sales price - Rs.15 Transfer price = Rs.9 per rackThe general transfer pricing rule result in goal congruent decision

making.



Scenario 2-Excess CapacityExcess capacity means that the total demand for its bread fromall sources, including the Gulf and Atlantic Divisions and theexternal market, is less than the bakerys productioncapacity.

T ransfer Pr ice = Outlay Cost + Opportunity Cost

Rs.8 per rack =Rs.8 per rack + Rs.O per rack



G

oal Congruence

Special price per rack(special order)Less: Transfer price paid by Gulf Division

Contribution to Gulf Division

Rs.10 per rack

Rs.8 per rack

Rs. 2 per rack

Suppose a local organization makes a special offer to the Gulf Division Managerto buy several hundred Loaves of bread to sell in a promotional campaign.Gulf Division accept the special offer, this is in the best interests of Suncoast FoodCenters. The company, as a whole, also will make a contribution of Rs.2 per rack onEvery transfer red to the Gulf Division to satisfy the special order.

Once again, the general Transfer pricing rule maintains goal congruentdecision making behavior.



Methods

Market Based Transfer Prices

Cost Based Transfer Prices

Negotiated Transfer Prices

Dual Transfer Prices



M

arket Based Prices

External Supplier

Buying DivisionSelling Division

External Buyer

Rs. 20/unit Rs. 20/unit

Rs. 20/unit

When the selling division does not have unused capacity (Total capacity 50,000 units)

50000 units 50000 units

50000 units



Uses of External Market Based Transfer Pricing

y Encourages division managers to focus on divisionalprofitability

y When aggregate divisional profits are determined for the year, the market-based transfer price help to assess thecontributions of each division to overall corporate profits



Example: Market Based Price

A company has 2 divisions, A and B. Division A manufactures acomponent which is used by Division B to produce a finished product.For the next period, output and costs have been budgeted as follow:

Division A Division B

Component units 50,000 -

Finished units - 50,000

Total variable costs Rs. 2,50,000 Rs. 6,00,000

Fixed Costs Rs. 1,50,000 Rs. 2,00,000

Please advise on the transfer price to be fixed for Division Ascomponent if it can sell the component in a competitive market forRs. 10 per unit and Division B can also purchase the component from

the open market at that price.



Example: Market Based Price

Solution:

Transfer price = Incremental (marginal) cost + Opportunity

cost of the company = Rs. 5 + Rs. 5

= Rs. 10

Hence, the transfer price of Rs. 10 is also equal to theto the market price of the component a v ailable at thesame price.



Cost-Based Pricesy Used when external markets do not exist or

information about external market price not readily

available

Variable Costctual ull

Cost

ull Cost PlusProfit Margin

StandardCost



Cost Based Prices: Variable Cost

External Supplier

Buying DivisionSelling Division

(unused capacity

20000 units)

External Buyer

Rs. 20/unit Rs. 20/unit

Rs. 10/unit(Variable cost)

30000 units 20000 units

20000 units

When the selling division has unused capacity (Total capacity 50,000 units)



Cost Based Prices:Actual Full Cost

Transfer Price = Full Cost of transferred product or

service

Full Cost = Variable Cost + allocated portion of fixedoverhead

y Selling division no longer has any incentive to improveits operating cost.



Cost-Based Prices: Full Cost plus

Profit. This method overcomes the weakness of Actual Full Cost

method, wherein the selling division cannot realize a profit ongoods and services.

Under this method, the transfer price includes the full cost perunit (direct materials, direct labor and factory overhead) plus amark up or profit allowance.

Since, the selling division obtains profit contribution underthis method, it benefits if performance is measured on thebasis of divisional operating profits.

However, the buying division of the organization would notreally agree to such a type of transfer pricing as the cost of buying would rise and will adversely affect the performance of the buying division.

Another challenge here is to determine the percentage of markup (profit rate) which ideally should cover operating expensesand provide a target return on sales or assets (investment).



Example:

The total investments of division A in a company is Rs. 10,00,000.

The volume of production is 4,00,000 units and the variable costper unit is Rs. 10. The fixed cost of production is Rs. 8,00,000. Thecompany desires 15% return on investment in Division A. What will be the transfer price for Division A.

Desired return on investment = 1,50,000 (15 % of 10,00,000)

Volume of Production = 4,00,000 units

Profit Margin/unit = 1,50,000/4,00,ooo = Rs 0.375


Profit.




Profit.

Amount (Rs.)

Variable Cost per unit - A 10.00

Fixed Cost per unit (8,00000/4,00,ooo) - Y 2.00

Profit Margin per unit - Z 0.375

Transfer price per unit (X+Y+Z) 12.375



As mentioned before, in actual cost approach, all product costsare transferred to buying division and hence, selling division isunder no pressure of controlling costs.

This results in cost variances or cost inefficiencies in the sellingdivision, which are thereby transferred to the buying division. Todistinguish these variances that have been transferred to thebuying division becomes extremely complex.

Hence, to eradicate this problem and to promote responsibility of cost control in the selling division, standard costs (decided costs)are usually used as basis of transfer pricing. It also helps increaseefficiency in the selling division.

Use of standard costs reduces the risk to the buyer as it helps avoidbeing charged with suppliers cost overruns.

Cost-Based Prices: Standard Costs



� Negotiated prices are generally preferred as middle solution between

market prices and cost-based prices.

� The Divisional Managers act the same as managers of independent

organizations or companies.

� Negotiated transfer prices is likely to be close to external market prices (as

explained earlier) when the Divisions are free to trade between each other as

well as in the external markets.

� However, it will be less than market price when the Selling Division has an

obligation of selling some of its total capacity to the Buying division (same

concept as unused capacity).

� The objectives of goal congruence, autonomy and perf ormance evaluation

can be achieved if Selling and Buying divisions can agree upon a mutual

transfer prices.

� However, this method requires a great deal of management eff orts and the

final negotiated price may depend on a Managers ability and skill to

negotiate rather than on the other factors.

Negotiated Transfer Price



Dual Transfer Pricing� Under this method, the Selling Division transfers goods at a profit (f ull cost

plus profit method) but the transfer price f or the Buying Division is the

market price.

�

The difference in the transfer price f or the two divisions is accounted f or by a special centralized account.

� The balances in the centralized account are then accounted f or against the

total profit of the organization as a whole.

� The main motive of this kind of transfer pricing is to provide incentives to

the Selling Division and also market price can be considered to be the most appropriate transfer price f or the Buying Division.

� This helps in the overall goals of decentralization goal congruence,

accurate perf ormance management , autonomy and adequate motivation to

divisional managers.

�

However, such a method is rarely used in deciding the transfer prices f or various division in the or anizations.



Dual Transfer PricingSelling Division Buying Division

Centralized Account

Organizational Profits

Balance transferred



Why MNCs use Transfer Pricing?Since each country has different tax rates, MNCs can increase their profits with the help of transfer pricing. By lowering prices in countries where tax rates are

high and raising them in countries with a lower tax rate, MNCs can reduce their

overall tax burden, thereby boosting their overall profits. That is why one often

finds that corporations located in high-tax countries hardly pay any corporate

taxes.

Transfer pricing, a very controversial and complex issue, requires closure scrutiny

not only by the critics of MNCs but also by the tax authorities in the developing

world. Transfer pricing is a strategy frequently used by MNCs to obtain huge

profits through illegal means. The transfer price could be purely arbitrary or

fictitious, theref ore different from the price that unrelated firms would have had

to pay. By manipulating a few entries in the account books, MNCs are able toreap obscene profits with no actual change in the physical capital.

For instance, a Korean firm manufacturers an MP3 player for $100, but its US

subsidiary buys it for $199, and then sells it for $200. By doing this, the firms

bottom line does not change but the taxable profit in the US is drastically

reduced. At a 30% tax rate, the firms tax liability in the US would be just 30 cents instead of $30.



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transfer pricing - final

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