transfer pricing(1)

8/3/2019 Transfer Pricing(1)

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MANAGEMENT CONTROLSYSTEMS

eMEP 10/ ePGP 03CA K.P.Rajendran


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Transfer Pricing

What is a transfer price?Purpose of Transfer Pricing

Objectives of Transfer PricingTransfer Pricing DecisionsTransfer Pricing Principles

Transfer Pricing RulesDifferent Methods of Transfer Pricing


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Transfer Pricing

For organizations that practicedecentralization, one of the principalchallenges is to devise a satisfactorytransfer pricing system.


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What is a Transfer Price?

Transfer price is the price that a profitcenter charges another profit centerfor the goods and services transferredby it.


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Purpose of Transfer PricingWhen two or more profit centers are

jointly responsible for productdevelopment, manufacturing, andmarketing, each should share in therevenue generated when the productis finally sold.The transfer price is the mechanismfor distributing this revenue.


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Purpose of Transfer Pricing

One of the principal reason for thetransfer pricing system is to create aperformance measurement systemwhich would ensure goal congruence.Another goal is to provide autonomyto profit centers which would ensureeffective decentralization.


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Objectives of Transfer Prices

The main objective of transfer pricingis to ensure proper distribution of revenue among profit centers and toprovide a means for measuring theeconomic performance of a businessunit.


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Transfer Pricing Principles

The fundamental principle of transferpricing is that the transfer price shouldbe similar to the price that would becharged if the product were sold tooutside customers or purchased fromoutside vendors.


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Transfer Pricing Rules

But how these outside selling pricesare determined?

For this the following general rule maybe applied:Transfer price = Outlay Cost +

Opportunity Cost


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Outlay Cost

Outlay cost is the additional amountthe selling business unit must incur toproduce and transfer a product orservice to another business unit.It is often the variable cost forproducing the item transferred.


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Opportunity Cost

Opportunity cost is the maximumcontribution that the selling unit

forgoes by transferring the iteminternally.


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Two situations may arise:The business unit operating at fullcapacity andThe business unit operating at less thanthe full capacity.


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Full capacity:

When the selling division is operating at full

capacity, it must forego external sales inorder to sell to another division.In such a situation, the transfer price is theoutlay cost for the division, which is

normally the variable cost, plus theopportunity cost, which is the contributionthe division foregoes on the external sale.


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This is nothing but the market price of the product.


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Under capacity:

The second consideration arises whenthe selling division operates at lessthan full capacity.Under this consideration, the transferprice would be the outlay cost which isnormally the variable cost.


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


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So as a general rule, the transfer priceshould be equal to variable costwhenever the selling division isoperating below capacity and atmarket price whenever it operates atcapacity.


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The transfer price mechanism shouldalso ensure goal congruence, that is,any decision to improve business unitprofits should also improve corporateprofits.


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Transfer Pricing Methods

Most corporations use any of thefollowing transfer prices:

Transfer price based on market priceTransfer price based on marginal costTransfer price based on full costTransfer price based on full cost plus a

markupNegotiated transfer pricesDual pricing


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Market-based Transfer Prices

Market based transfer prices are the besttransfer prices to evaluate the performanceof the profit center and to ensure goal

congruence.If competitive market price exists or can beapproximated for the product it should beused. If there is no way of approximating

valid competitive prices, the other option isto develop cost-based transfer prices.


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Companies using market-basedtransfer prices set the transfer price atthe competitive market price for theproduct after making adjustments forthe difference between the internaland external sales like:

Marketing and selling costsDiscountsDistribution costs, etc


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The market price used for internaltransfers may be:

Listed price of an identical product orserviceThe actual price the selling divisioncharges external customers

The price a competitor is offering.


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Advantages:Ensure goal congruence

It is optimal for both decisionmaking and performance evaluationIt provides proper motivation to the

managers.


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Disadvantages:Often there may not be a

competitive market for the product


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Market-based Transfer PricesA market price-based transfer price willinduce goal congruence if all followingconditions exist in practice:

Competent people: Managers should beinterested in the performance of their profitcenters.Good atmosphere: Managers should regardprofitability as an important goal and asignificant measure of their performance.Existence of a competitive market price:


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Cost based Transfer Prices

When the transferred goods orservices do not have a well-definedmarket price, one of the alternativesto consider would be a transfer pricebased on cost.


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Transfer Price based on MarginalCost

Standard variable cost or standard direct costof production is used as the transfer price.Advantages

Optimize the profits at the corporate levelDisadvantages

Profits of the selling division is understatedand profits of the buying division isoverstatedProvides a poor measure for evaluating theperformance of the business unit and its themanager.Difficult to implement.


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Full-Cost transfer Prices

Many companies use full-cost transferprices

Advantages:Relatively easy to implementWill not distort the evaluation process asthe selling profit center is allowed to

recover the full cost of production.


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Full-Cost transfer Prices

Disadvantages:Cost of capital is not reflectedOverhead allocation may be arbitrary.Does not provide an incentive forinternal transferUnderstate the entitys profit


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Full Cost plus Markup TransferPrices

The price is determined by adding a fixedmarkup to the full cost.Advantages:

Allow the selling profit center to earn a profitProvides an approximation of market pricewhere no competitive external market priceexists.

Disadvantages:May not provide an optimal decision at thecorporate level.


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Negotiated Transfer Prices

This is a popular pricing alternativeused by many companies.The policy can be effective if bothprofit centers have some bargainingpower; that is, the selling profit centerhas some possibilities to sell itsproduct outside the company and thebuying profit center has some outsidesources of supply.


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Negotiated Transfer Prices

Advantages:Open negotiation allows the managers to makeoptimal decisions

Disadvantages:Negotiation of the price of a potentially largenumber of transactions is costlyOften accentuates conflict between profit center

managersOutcome often depends on the negotiation skillsand bargaining power of the managers involved.


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Dual Pricing

In this method, the manufacturingunits revenue is credited at theoutside sales price and the buying unit

is charged the total standard costs.The difference is charged to aheadquarters account and eliminatedwhen the business unit statements areconsolidated.


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Dual Pricing

This transfer pricing method is usedwhen there are frequent conflictsbetween the buying and selling unitsthat cannot be resolved by one of theother methods. Both the buying andselling units benefit under this

method.


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Dual Pricing

AdvantagesBoth the buying and selling units benefit underthis method.

DisadvantagesThe sum of the business unit profits is greaterthan overall profits of the company.This system might motivate business units to

concentrate more on internal transfers wherethey are assured of a good markup at theexpense of the outside sales.

transfer pricing(1)

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