You are on page 1of 6

MEANING OF TRANSFER PRICE The transfer price is the price that one division of a company charges another division

of the same company for a product transferred between the two divisions.1 It refers to the amount used in accounting for transfer of goods or services from one responsibility centre to another or from one company to another which belongs to the same group. TRANSFER PRICING DEFINED Transfer pricing is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services.2 It is simply the act of pricing of goods and services or intangibles when the same is given for use or consumption to a related party (e.g. Subsidiary)3 Suppose a company A purchases goods for 100 rupees and sells it to its associated company B in another country for 200 rupees, who in turn sells in the open market for 400 rupees. Had A sold it direct, it would have made a profit of 300 rupees. But by routing it through B, it restricted it to 100 rupees, permitting B to appropriate the balance. The transaction between A and B is arranged and not governed by market forces. The profit of 200 rupees is, thereby, shifted to the country of B. The good is transferred on a price (transfer price) which is arbitrary or dictated (200 hundred rupees), but not on the market price (400 rupees).4 OBJECTIVES OF TRANSFER PRICING Transfer pricing systems are designed to accomplish the following objectives5: To provide each division with relevant information required to make optimal decisions for the organization as a whole; To promote goal congruence that is, actions by divisional managers to optimize divisional performance should automatically optimize the firms performance; To facilitate measuring divisional performance.

Heath, Huddart, & Slotta, The Fuqua School of Business International Strategy: Duke University

2
3

Asish K Bhattacharyya, transfer pricing explained, accounting, New Delhi June 30, 2008
Mayank K Agrawal, transfer Pricing a biginners perspective, Incometaxindia.gov.in

4
5

PURPOSE OF TRANSFER PRICING There can be internal and external reasons for transfer pricing. Internal include motivating managers and monitoring performance, e.g. by putting a cost to imported inputs. External would be taxes and tariffs. Generate separate profit figures for each division and thereby evaluate the performance of each division separately. Help coordinate production, sales and pricing decisions of the different divisions (via an appropriate choice of transfer prices). Transfer prices make managers aware of the value that goods and services have for other segments of the firm. Transfer pricing allows the company to generate profit (or cost) figures for each division separately. The transfer price will affect not only the reported profit of each center, but will also affect the allocation of an organizations resources.6 METHODS OF TRANSFER PRICING There are various transfer pricing methods in use. These methods are generally based on either i) cost, ii) market price. The following are the important types or methods of intra-company transfer price: i) Cost price

According to this method, goods and services are transferred from one segment of the company to another on the basis of unit cost of production of the transferring division. The cost could be either be taken to be the actual cost of production or the standard cost of production. ii) Cost plus a normal mark up

In this type, the buying division is charged the actual unit cost of production of the transferring department, whatsoever it may be, plus a mark up for profit. iii) Incremental cost

Incremental cost can be computed in two ways depending upon the circumstances. In case entire production is transferred to another division within the same company, the incremental cost will be the total of variable cost of transferring centre plus any fixed costs which are directly attributable to that centre/division.
6

Heath, Huddart, & Slotta, The Fuqua School of Business International Strategy: Duke University

The second approach may be when goods and services are sold to outside customers as well as transferred within the same company. In such a case, incremental cost may be taken as the opportunity cost in the form of loss of revenue which the transferring division would have charged from the outside customers. iv) Shared profit relative to the cost

According to this method no price is charged for the intra company transfers. Rather out of the total sales revenue of the company the aggregate cost of various divisions is deducted to find out the profit for the company as a whole. v) Market price

In this method, the prices charged for intra-company transfers are determined on the basis of market price and not on the cost basis. There are three ways of computing the market price: a) The prevailing market price, after making adjustments for discounts and other selling costs. b) Where active market does not exist, or where market price is not available, cost plus a normal profit may be taken as a reasonable market price. c) The company can invite bids from the market so as to determine market price. vi) Standard price

Transfer prices can also be fixed on predetermined standard price basis. The standard price may be determined on the basis of cost of production and the prevailing market conditions. vii) Negotiated price

The intra-company transfer price can also be determined on the basis of negotiations between the buying and the transferring division. viii) Dual or two way price.

According to this method, the transferring division is allowed to give credit at one price, whereas, the buying division is charged at a different price. It enables better evaluation of profit centers and avoids conflict among them on account of transfer price. COST BASED TRANSFER PRICE METHOD This method is generally used where semi finished products are transferred. According to this method the selling division sells the intermediate product to external customers as well as to the buying division. If the selling division has excess capacity, a cost-based transfer price using

variable cost of production will align incentives, because the selling division is indifferent about the transfer, and the buying division will fully incorporate the companys incremental cost of making the intermediate product in its production and marketing decisions. If the selling division has a capacity constraint, transfers to the buying division will displace the external sales. In this case, in order to align incentives, the opportunity cost of these lost sales must be passed to the buying division, which is accomplished by setting the transfer price equal to the selling divisions external market sales price. Now let us consider the case in which there is no external market for the selling division. If the selling division is to be treated as a profit centre, it must be allowed the opportunity to recover its full cost of production plus a reasonable profit. If the buying division is charged the full cost of production, incentives are aligned because the buying division will refuse the transfer under only two circumstances: First, if the buying division can source the intermediate product for a lower cost elsewhere; Second, if the buying division cannot generate a reasonable profit on the sale of the final product when it pays the selling divisions full cost of production for the intermediate product. In common, for reason of apply a cost-based method, costs are divided into three categories: 1. Direct costs:- raw materials; 2. Indirect costs:- repair and maintenance which may be allot among several goods. 3. Operating expenses:- selling, general, and organizational expenses. The cost plus method uses limits calculated after direct and indirect costs of goods. Correctly shaping cost under the cost plus method is important. Cost is typically calculated in agreement with accounting values that are usually accepted for that exacting industry in the region where the products are produced.

MARKET BASED TRANSFER PRICE When divisional managers strive to maximize divisional profits, a market-based transfer price aligns their incentives with owners incentives of maximizing overall corporate profits. The selling division is generally indifferent between receiving the market price from an external customer and receiving the same price from an internal customer. Consequently, the determining factor is whether the buying division is willing to pay the market price. If the buying division is willing to do so, the implication is that the buying division can generate incremental profits for the company by purchasing the product from the selling division and either reselling it or using the product in its own production process. On the other hand, if the buying division is unwilling to pay the market price, the implication is that corporate profits are maximized when the selling division sells the product on the external market, even if this leaves the buying division idle. Sometimes, there are cost savings on internal transfers compared with external sales. These savings might arise, for example, because the selling division can avoid a customer credit check and collection efforts, and the buying division might avoid inspection procedures in the receiving department. Market-based transfer pricing continues to align managerial incentives with corporate goals, even in the presence of these cost savings, if appropriate adjustments are made to the transfer price (i.e., the market-based transfer price should be reduced by these cost savings). However, many intermediate products do not have readily-available market prices. Obviously, if there is no market price, a market-based transfer price cannot be used. A disadvantage of a market-based transfer price is that the prices for some commodities can fluctuate widely and quickly. Companies sometimes attempt to protect divisional managers from these large unpredictable price changes.

Transfer pricing model Each country is following its own model of Transfer Pricing analysis, but most of the countries are following OECD (Organization for Economic Cooperation and Development) model of convention on Transfer Pricing. Some are following UN Model of TP also.

India is following its own model of Transfer Pricing under the Income-tax Act and IT Rules and India is an observer of OECD Model of convention on Transfer Pricing. India is a non-member in OECD.