Transfer Pricing

Transfer Pricing:- a Transfer pricing is the internal price charged by a selling department,
division or subsidiary of a company for a raw material , component or finished goods or
services which is supplied to a buying department, division or subsidiary of the same
company.
The concept of transfer price is fundamentally aimed at simulating external market
conditions within the organization so that the managers of individual business unit are
motivated to perform well.
It does not have any direct accounting impact on the organizations profit as a whole
because its effect on the selling divisions revenue is matched by its effect on the buying
divisions cost . However when the profits of the selling and buying division are taxed at
different rates, there is some impact on the organizations profits as a whole.
Transfer pricing mechanism work in different ways, if all the divisions are completely
independent of each other, then the selling division will sell its product to the buying
division only at the market price.
Objectives of Transfer Pricing Policy:According to Robert Anthony and Vijay Govindarajan, the fundamental principle 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 vendor. The main
objective of transfer pricing is the proper distribution of revenues and costs between
responsibility centers . If two or more profit centers are jointly responsible for developing
and marketing the product then the resulting profit has to be shared between them.

Broadly there are three objectives of transfer pricing:-

Objective of Transfer Pricing

Goal Congruence
1.

2.

3.

Performance Appraisal

Division Autonomy

Goal congruence:-while designing the mechanism for transfer pricing , the interest of
individual profit centers should not supersede those of the organization as a whole. The
division manager in maximizing the profits of his/her division should not engage in
decision making that fails to optimize the organizations performance.
Performance appraisal:- transfer pricing should aid in reliable and objective assessment of
the activities of profit centers. Transfer prices should provide relevant information to guide
decision making , assess the performance of divisional manager and also assess the value
added by profit center toward the organization as a whole.
Divisional autonomy:-the transfer pricing should aimed at providing optimum divisional
autonomy , thereby allowing the benefits of decentralization to be retained . Each
divisional manager should be free to satisfy the requirements of his/ her profit center form
internal or external sources. There should be no interference in the process by which the
buying center manager rationally strives to minimize the costs and the selling center
manager strives to maximize revenues.

In reality , it is difficult to simultaneously meet all these objectives.

for example:- there may be the situation of excess capacity in the industry . It would not be
prudent for the selling profit center to sell to the external market when there is excess
industry capacity . However due to this excess industry capacity the buying profit center
would want to buy from external market to reduce its costs rather than procure the
resources available within the organization . As a result if divisional autonomy is to be
retained and transfer prices are considered for performance appraisal the objective of goal
congruence may not be achieved.
For the organization operating in many countries , internal transfer pricing can be a
determinant of where profits are to be declared and taxes paid.
The fact that the different countries have different tax and exchange rates has to be taken
into consideration in case of transactions with sister concerns that supply intermediary
products.
The transfer pricing should enable multinational corporations to minimize tax liability .
Transfer pricing objectives in International Business:Apart from the objectives of the transfer pricing policy between responsibility centers in
domestic operations, multinational corporations must take into consideration several other
factors for arriving at their transfer pricing policy that is applicable between the legal
entities in different countries.

Some of these factors are:1. Manage exchange rate fluctuation

2. Handle competitive pressure
3. Reduce impact of taxes and tariffs
4. Movement of funds between countries
1.

Manage exchange rate fluctuation:- multinational corporation can reduce exchange rate
risk by transfer pricing . When the currency depreciates , the purchasing power of the
currency declined. Therefore ,organization based in that country may have to pay more of
imports . On the contrary , if the currency appreciates , the revenues from exports will fall
for organizations based in that country. But multinational corporation can depend on their
subsidiaries for import and exports and use transfer prices to manage exchange rate
fluctuations.
e.g. they can import products at their fixed transfer prices and not at the higher prices due to
depreciation of the local currency.
2. Handle competitive pressures:- the subsidiaries of an organization operating in different
countries can use transfer pricing to lower prices to match local competition.
e.g. garment manufactures in Europe depend mainly on China , Japan and India for silk .
Therefore , if an organization has subsidiaries in these countries , it may manage to get silk at a
lower cost by transfer pricing . Thus, it will be able to reduce the price of the finished
products to match or undercut local competition.

3.

Reduce the impact of taxes and tariffs :-many multinational corporations make use of
transfer pricing to reduce their total tax liability. Organization try to maximize profits in
countries where corporate taxes are lower thus reducing the tax liability of tariffs on
imports through transfer pricing when purchasing products from the overseas business
units of the organization.
e.g. the exporting business units can quote a lower selling prices. This will result in lower tariffs
for the importing business unit, since most duties are levied on the value of the goods
imported.
4. Movement of funds between countries:- a multinational corporation may prefer to invest
its funds in one country rather than another . Transfer pricing providing an indirect way of
shifting funds into or out of a particular country.

Method of calculating transfer prices:1.

Market-based pricing method:- organization that uses this method price the goods and
services they transfer between their profit centers at a level equal to the prevailing open
market price for those goods and services.
Advantage of market based pricing method: The division can operate as independent profit centers with the managers of these units
being completely responsible for performance of their business units.
This increases their motivation
Makes it easy for the top management to assess the performance of the individual
divisions.
Tax and custom authorities favor market price method as it is transparent and they can
cross-check the price details provided by the organization by comparing them with market
prices on that date.

Problems with market based pricing method: There is no competitive market which can provide comparable price.
There is variation in the prices between one market and another due to difference in
exchange rates, transportation cost, local taxes and tariffs etc.

2.

3.

Negotiated pricing method:In this method of transfer pricing , the buying and selling division negotiate a mutually
acceptable transfer prices.
Since each division is responsible for its own performance, this will encourage cost
minimization and encourage the parties to seek a transfer price that yields them an
appropriate return.
Tax authorities have reservation about this method because it gives organization greater
scope to manipulate the transfer prices and thus minimize their tax liability.
Cost plus method:It is the simplest method of transfer pricing is to use full historical cost.
The full cost of product is material , labor and overhead cost required to produce and ship
the product to the buying unit.
Full costs are the most economical transfer prices to develop because they are routinely
prepared for inventory evaluation.
However if the goods are transferred at cost then the selling division is only a cost center,
or profit center budgeted at zero profitability if standard costs are used as the transfer
prices.
Some firms have attempted to use simple cost based transfer prices yet provide for profit
by adding a normal markup to cost. This method produce artificial profit system which is
dictated by corporate policy on markups rather than by market forces.

4.

Marginal cost:the marginal cost of a unit is the additional cost required to produce it.
If the transfer pricing system is designed to ensure efficient allocation of resources than the
best transfer price to use is marginal cost.
Decision making based on incremental cost determines the benefits of the decision for the
organization as a whole.
At less than full capacity, marginal cost consist of the variable costs of producing and
shipping goods plus any cost directly associated with the transfer.
At full capacity , however incremental cost must reflect the opportunity lost by foregoing
sales to outside customers. In this situation, incremental cost is equal to market prices.

Significance of Transfer pricing

Transfer pricing serves the following purposes.

When product is transferred between profit centers or investment centers within a

decentralized firm, transfer prices are necessary to calculate divisional profits, which then
affect divisional performance evaluation.
When divisional managers have the authority to decide whether to buy or sell internally or
on the external market, the transfer price can determine whether managers incentives align
with the incentives of the overall company and its owners. The objective is to achieve goal
congruence, in which divisional managers will want to transfer product when doing so
maximizes consolidated corporate profits, and at least one manager will refuse the transfer
when transferring product is not the profit-maximizing strategy for the company.
When multinational firms transfer product across international borders, transfer prices are
relevant in the calculation of income taxes, and are sometimes relevant in connection with
other international trade and regulatory issues.

Factors affecting transfer pricing

With the government across the world tightening taxation regulations for import-exports and
foreign exchange remittance , many organization are setting up specialized in house
transfer pricing departments rather than leaving the function to taxation or accounts
departments. Some of the conditions which are necessary for the development of a proper
transfer pricing mechanism are: Role definition
External advisor
Competent manager
Equity
Information on prevailing market prices
Proper investment.

Role definition:- the role and scope of the team responsible for transfer pricing should be
clearly defined. There should not be any confusion about the functions of the transfer team.
There should be clear demarcation of activities between the transfer pricing team and the
accounts and taxation teams and a document setting out each teams responsibility should
be circulated to all those involved. This also ensure that all the necessary tasks are
allocated.

2.

External advisor:- when necessary the organization must be ready to appoint external
adviser whose knowledge and experience will be valuable to the transfer pricing team and
who can provide resources not available in house. He will help the organization to see the
bigger picture, which in house team may not be able to do.

3.

Competent managers:- organization need mangers who can balance long term and short
term goals . Managers are often accused of sacrificing the long-term gains for short-term
profits. This approach can prove to be disastrous for the organization. Transfer pricing can
be misused for manipulating profits and this gives a wrong picture of the organizations
position. Hence the organization should have competent people skilled at negotiation and
arbitration, who are capable of determining the appropriate transfer prices such that long
term goals are not sacrificed for shot term gains. There must be a mechanism for
negotiating contracts and the managers who take transfer pricing decisions should be
trained in art of negotiation.

4.

Equity:- in order to achieve goal congruency, mangers of profit centers , especially the
buying profit centers, should ensure that the transfer prices charged by the selling profit
centers are fair. This will create atmosphere of trust between the sister concerns . The
managers of the selling profit centers should be give the freedom to sell their goods in the
external market , while mangers of the buying profit centers should have the option of
buying their goods from the external market. The market will thus become the main
determinant of the transfer price.

5.

Information on prevailing market prices:-when the product is transferred from one

profit center to another, the normal market price for an identical product can be taken as
basis for establishing the transfer price. While taken the market price of identical product
as a reference , the quality and quantity of the reference product should be identical to
those of product whose transfer price is to be fixed. Demand and supply in the market
during the time of delivery should also be considered. As the product is sold within the
organization , the expenses on advertising and marketing are lower and the market price
can be adjusted to reflect the saving that accrue due to these lower expenses.
Manger should be fully aware of market conditions and should have all t he necessary
information regarding available options and the cost and revenues of each , before they
take any decision on whether to purchase from outside suppliers or to resort to in-house
sources.
6.

Proper investment:- the transfer pricing department must be well funded and should
coordinate well with other departments in the same organization, the transfer pricing
departments of other business units as well as the top management. It is very important for
the enterprise to comply with transfer pricing jurisdiction and to maintain documentation
of transfer pricing in order to deal satisfactorily with any legal issues that may arise.

Constraints while determining the transfer price:-

External constraints
1.
2.

Internal constraints

Limited market
Excess or shortage of industry capacity
External constraints :- these are the constraints which are imposed by the external
environment .like government regulations, climate conditions and those which
cannot be controlled by the organization are called external constraints. Some of
these constraints are :1. Limited market:-the market for buying and selling the goods of the profit
center may be either very small or even nonexistent. in case of MNCs , if intra
organizational trade take place between the divisions or subsidiaries in
different countries, the interest of the organization may be in conflict with the
interests of one or more of the countries. In such cases also the options for the
organization to source internally become limited.
Eg. Consider an organization in US that wants to buy an intermediate product from
its sister concern in UK at a transfer price that is much lower than the market

Price . This transaction will record a very low or even zero profit for the organization
in the UK and thus will reduce its tax liability. Therefore the UK government
might not allow this transactions below market price. In such as case , the
organization in the US will have no option but to pay a price closer to the
market price.
2. Excess or shortage of industry capacity:- there may be a situation of excess
capacity or shortage of capacity in the industry in which an organization
operates. In such a situation the business unit may not consider all opportunities
available to them.
An example of this situation is when there is a shortage in the industry and the
buying center is not able to procure form outside because the price in the market
is high whereas the selling profit center is selling in the outside market.
The reverse is the situation occurs when there is excess capacity in the industry. The
buying profit center may purchase form outside vendors even though there is
capacity available within the organization.
When there is an excess or shortage of industrial capacity , the sourcing decisions
taken by the organization are of critical importance. An organization may allow
its buying profit center to buy goods from outside if it is getting better deal

In terms of quality, price and service. Similarly a selling profit center may be
allowed to sell its products in the open market if it gets a higher profit by doing
so. Otherwise the organization may appoint a central body to arbitrate on such
issues. Whatever be the case the management should try to take decisions that
optimize the profits of the organization.
2.

Internal constraints:-the constraints imposed and controlled by the

organization itself are called internal constraints. An internal constraints may
arise when the existence of excess internal capacity forces the buying division
not to purchase from outside sources. Another situation where an organization
makes a significant investment facilities , then it will not buy the goods from
outside sources even though the outside capacity exist.

Because of these constraints , it is very difficult to implement a perfect transfer

mechanism in an organization. So management should be forced to set a cost
based price, which is acceptable to both the selling and buying centers as a
transfer price.