Transfer Pricing

By Punit Kumar Dwivedi (AIMA) BBCIT

Definition
Value placed on transfers within an organization,

used as a means of allocating costs to various profit centers is transfer pricing.

The price at which divisions of a company transact

with each other. Transactions may include the trade of supplies or labor between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities.

Objectives of TP
1. It should provide each business unit with the

relevant information. 2. It needs to determine optimum trade off between companies cost and revenue. 3. It should induce the goal congruence decision to improve units profit. 4. It should help to measure the economic performance of individual business unit. 5. The system should be simple to understand and easy to administer.

Criteria for validity & acceptability of TP

1. TP should be objectively determined.

2. TP should be equal to the value of the

intermediate product being transferred.

3. TP should be compatible with a policy that

maximises attainment of the companies goal and evaluation of segments performance.

Factors affecting TP
Performance measurement. Capability of accounting system. Inport quotas. Custom duties. VAT. Taxes on profit

Uses of TP
1)

Price setting for services performed by business unit.

2)

A mean of evaluating financial performance of business unit.

3) 4) 5)

Determining the contribution to net profit by profit centers in org. Reduce in corporate taxes paid. Reduce in VAT , excise, tariffs.

Fundamental Principle
1. The transfer price should be similar to

the price that would be charged if The product were sold to outside customers or Purchased from vendors.

TP policies
That refers to selection of policies that

would govern the calculations of such prices under various circumstances. The concern of TP policies are with developing a TP system that allows1)Performance measurement 2)Decision optimization a) Optimal utilization of resources b) Cost of goods c) Services transferred between unit d) Opportunity cost, mkt. price

Fundamental decisions
Should the company produce the product

inside the company or purchase from out side vendor ?

This is sourcing decision.

If produced inside at what price should the

product be transferred between profit centers?

This is transfer pricing decision.

Transfer Pricing
A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. Intermediate products are the products transferred between subunits of an organization.

Transfer-Pricing Methods

Market-based transfer prices Cost-based transfer prices Negotiated transfer prices

Transfer-Pricing Methods Example

Lomas & Co. has two divisions: Transportation and Refining. Transportation purchases crude oil in Alaska and sends it to Seattle. Refining processes crude oil into gasoline.

Market-Based Transfer Prices

By using market-based transfer prices in a perfectly competitive market, a company can achieve the following: Goal congruence Management effort Subunit performance evaluation Subunit autonomy

Market-Based Transfer Prices

Market prices also serve to evaluate the economic viability and profitability of divisions individually.

Cost-Based Transfer Prices

If

competitive prices are not available transfer prices may be set on the basis of Cost-Plus a profit. Two decisions must be made in a cost based TP sys. 1)How to define cost. 2)How to compute the profit markup. The usual basis is standard costs. Actual cost should not be used because production inefficiencies will be passed on to the buying profit center.

TP & profit share system

This system operates as follows:1)The product is transferred to marketing unit at Standard variable cost. 2)After selling of product the business unit Shares the contribution earned which is Selling price-VC& marketing cost.

Problems of profit sharing system

Argument

over the way of deviding profits between two profit centers. Arbitrary dividing up the profit between units does not gives valid information on the profitability of each unit. The mfg. units contribution depends upon the marketing units ability. Manufacturing unit may perceive this unfair bad situation.

Recommendations
If

competitive prices are not available , TP may set on the basis of cost plus profit, even though such TP may be complex to calculate and the results less satisfactory than a market based price. Cost based TP can be made at std. Cost +PROFIT margin, or by the use of TWOSTEP PRICING SYSTEM. In tsps the mfg.units revenue is credited at the Outside sales price and the buying unit is charged The total std. cost. The difference is charged to HQ.

ANY QUESTIONS ?

Thank You
All the Best