Transfer Pricing

Introduction

Transfer price is the price at which related parties transact with each other, such as during the
trade of supplies or labour between departments. Transfer prices are used when individual
entities of a larger multi-entity firm are treated and measured as separately run entities. It is
common for multi-entity corporations to be consolidated on a financial reporting basis;
however, they may report each entity separately for tax purposes.

A transfer price can also be known as a transfer cost.

Purpose of Transfer Pricing

(1) Optimum use of inter departmental resources and increases efficiency.

(2) Since autonomy is granted to decentralize units, it is normally believed that they are
free to exercise their rights either to transfer or not goods and services.

(3) Helps increasing profitability of the firm

(4) Used as a tool for minimization of tax

(5) Generates managerial affairs towards inter-divisional healthy competition and

application of each other difficulties.

(6) Decentralization is the pre-condition for use of transfer pricing.

(7) It is a panacea to ideal capacity sickness

(8) Divisional autonomy and individual profit responsibility generally lead too much
greater success and profitability.

(9) To impose the correct transfer price top managers would have to know details about
the intermediate market, variable cost and capacity utilization.

How Transfer Prices Work

A transfer price arises for accounting purposes when related parties, such as divisions within
a company or a company and its subsidiary, report their own profits. When these related
parties are required to transact with each other, a transfer price is used to determine costs.
Transfer prices generally do not differ much from the market price. If the price does differ,
then one of the entities is at a disadvantage and would ultimately start buying from the market
to get a better price.

For example, assume entity A and entity B are two unique segments of Company ABC.
Entity A builds and sells wheels, and entity B assembles and sells bicycles. Entity A may also
sell wheels to entity B through an intracompany transaction. If entity A offers entity B a rate
lower than market value, entity B will have a lower cost of goods sold (COGS) and
higher earnings than it otherwise would have. However, doing so would also hurt entity A's
sales revenue.

If, on the other hand, entity A offers entity B a rate higher than market value, then entity A
would have higher sales revenue than it would have if it sold to an external customer. Entity
B would have higher COGS and lower profits. In either situation, one entity benefits while
the other is hurt by a transfer price that varies from market value.

Regulations on transfer pricing ensure the fairness and accuracy of transfer pricing among
related entities. Regulations enforce an arm’s length transaction rule that states that
companies must establish pricing based on similar transactions done between unrelated
parties. It is closely monitored within a company’s financial reporting.

Transfer pricing requires strict documentation that is included in the footnotes to the financial
statements for review by auditors, regulators, and investors. This documentation is closely
scrutinized. If inappropriately documented, it can burden the company with added taxation or
restatement fees. These prices are closely checked for accuracy to ensure that profits are
booked appropriately within arm's length pricing methods and associated taxes are paid
accordingly.

Special Consideration

International Taxation and Transfer Prices

Transfer prices are used when divisions sell goods in intracompany transactions to divisions
in other international jurisdictions. A large part of international commerce is actually
done within companies as opposed to between unrelated companies. Intercompany transfers
done internationally have tax advantages, which has led regulatory authorities to frown upon
using transfer pricing for tax avoidance.

When transfer pricing occurs, companies can manipulate profits of goods and services, in
order to book higher profits in another country that may have a lower tax rate. In some cases,
the transfer of goods and services from one country to another within an intracompany
transaction can also allow a company to avoid tariffs on goods and services exchanged
internationally. The international tax laws are regulated by the Organisation for Economic
Cooperation and Development (OECD), and auditing firms within each international location
audit the financial statements accordingly.

Methods of Transfer Pricing

Methods of determining transfer price

There are few methods of determining transfer pricing namely,

1. Direct manufacturing cost

This methods involves transfer of goods at direct manufacturing cost incurred by the
production division. When a buying subsidiary acquires products at very low price, it
has no incentive to minimize expenses. Moreover, the selling unit cannot show profit
for inter-firm transfer at manufacturing cost. In this sense, direct manufacturing cost
method does not encourage the selling unit as well as the buying unit. This is can be
determined on the basis of-
i. Full cost
ii. Variable cost
iii. Standard cost
iv. Conversion cost
v. Opportunity cost

2. Direct manufacturing cost plus a predetermined markup to cover additional expenses

This method is an improvement over direct manufacturing cost method. Under this
method, merchandise is transferred at a price which covers both the manufacturing
cost and a predetermined markup to cover additional expenses. The chief merit of this
 method is that profit is produced and added at every stage. This can be determined on
the basis of-
i. Full cost plus
ii. Variable cost plus
iii. Standard cost plus
iv. Opportunity cost plus

3. Market based transfer price

Market based transfer price overcomes the limitations of manufacturing cost plus
markup. The price is determined purely on the basis of market conditions. Though the
market based transfer price considers market conditions sometimes, it may not cover
up production costs. This can be determined on the basis of

i. On prevailing market price

ii. On negotiating market price

iii. On synthetic market price

4. According to the general rule:

This method can be applied for some different conditions. They are

i. When ideal capacity exists

ii. Considering variable cost plus opportunity cost
iii. When ideal capacity does not exists
iv. When variable cost and opportunity cost, which is the difference
between the market price and transfer price.
5. Dual Transfer pricing
Transfer prices that are set at different levels for the supplying and receiving divisions
of an organization. The dual prices method charges a low price, say a price based on
the marginal cost, to the buying division, while at the same time crediting a high
price, say a price based on full cost pricing, to the selling division. 

Besides, there are some other methods of transfer pricing

1. Dictated transfer pricing

2. Arbitrary Transfer pricing
 3. At Shadow price

Example worked out

JoyRide inc. has motorbike manufacturing division and sales division. The manufacturing
divisions in Vietnam make a motorbike and sells it at $2000 per unit. Total cost of production
per unit is $1500. The sales division in USA is responsible for the import, transportation,
stock and sales and hence sells of the bikes at $3000 per unit, with a 5% of import duty. The
motorbikes are manufactured at a state, where the income tax is 25% and the sales division
have a corporate income tax of 40%. Both the divisions have an average estimated fixed
overhead cost of $200 per unit.

a. What is the net profitability of JoyRide in this transfer pricing model

b. What is the net profit of the company per unit, if the manufacturing division sells the
bikes for $2400 per unit?

Solution:

Manufacturing Sales Consolidated

Division Division Company
a) Sales revenue 2000 3000 3000
Cost of goods sold 1500 2000 1500
Import duty 5% - 100 100

Gross profit 500 900 1400

FC 200 200 400
EBIT 300 700 1000
Tax 75 280 355
Net Income 225 420 645

b) Sales revenue 2400 3000 3000

Cost of goods sold 1500 2400 1500
Import duty 5% - 120 120

Gross profit 900 480 1380

FC 200 200 400
EBIT 700 280 980
Tax 175 112 287
Net Income 525 168 693
Here we can see that the transfer pricing method helps to increase the overall profitability of
the Company.