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Transfer Pricing

Chapter 6

Transfer Price
The amount charged when one division of an organization sells goods or services to another division. The exchange is internal and does not affect the organization’s total sales or profit.
Battery Division The higher the transfer price to the auto division, the . . . greater is the profit of the battery division.

Auto Division

Objectives of Transfer Prices
• Provide each business unit with the relevant information it needs to determine the optimum trade-off. • Induce goal congruent decisions. • Help to measure the economic performance of the individual business units. • Simple to understand and easy to administer.

Types of transfer pricing methods
• • • • • • Market price Cost-based Transfer Prices Agreement among Business Units Two-Step Pricing Profit Sharing Two Sets of Prices

Upstream Fixed costs and profit

1. Market Price
The Fundamental Principle 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 vendors.

Decisions must be made periodically for each product:
1. Sourcing decision: Should the company produce the product inside the company or purchase it from an outside vendor? 2. Transfer price decision: If produced inside, at what price should the product be transferred between profit centers?

The ideal Situation
A Market price-based transfer price will induce goal congruence if all the conditions listed below exist. • Competent People • Good Atmosphere • A Market Price • Freedom to Source • Full Information • Negotiation

Competent People :Staff people involved in negotiation and arbitration of transfer prices must be competent. Good Atmosphere : Managers must regard profitability, as measured in their income statements, as an important goal. A Market Price :The ideal transfer price is based on a well-established, normal market price for the identical product being transferred

Freedom to Source : The buying manager should be free to buy from the outside, and the selling manager should be free to sell outside Full Information: Managers must know about the available alternatives and the relevant costs and revenues of each. Negotiation: There must be a smoothly working mechanism for negotiating “contracts” between business units.

Constraints on Sourcing
In real life, freedom to source might not be feasible. Managers may not have the freedom to make sourcing decisions in following conditions : • Limited Markets • Excess or Shortage of Industry Capacity

Limited Markets
In many companies, markets for the buying or selling profit centers may be limited because of : • The existence of internal capacity might limit the development of external sales. • If a company is the sole producer of a differentiated product, no outside source exists. • If a company has invested significantly in facilities, it is unlikely to use outside sources unless the outside selling price approaches the company’s variable cost, which is not usual.

Limited Markets(contd.)
Company decides the competitive price,if it does not buy or sell the product in an outside market by : 1. Published market prices. 2. Market prices set by bids. 3. If the production profit center sells similar products in outside markets. 4. If the buying profit center purchase similar products from the outside market.

Excess or Shortage of Industry Capacity
• The selling profit center cannot sell to the outside market all it can produce – that is, it has excess capacity.

• The buying profit center cannot obtain the product it requires from the outside while the selling profit center is selling to the outside. This situation occurs when there is a shortage of capacity in the industry.

2.Cost-Based Transfer Prices
• If competitive prices are not available, transfer prices may be set on the basis of cost plus a profit. • Disadvantages: 1. complex to calculate 2. results less satisfactory than a marketbased price. Two decisions must be made in a cost-based transfer price system: (1) how to define cost and (2) how to calculate the profit markup.

• The Cost Basis: The usual basis is standard costs. Actual costs should not be used because production inefficiencies will be passed on to the buying profit center. If standard costs are used, an incentive is needed to set tight standards and improve standards. • Profit Markup: In calculating the profit markup, there also are two decisions: (1) what the profit markup is based on and (2) the level of profit allowed.

Upstream fixed Costs and Profit
Even if the final profit center were aware of the upstream fixed costs and profit, it might be reluctant to reduce its own profit to optimize company profit. Methods that companies use to mitigate this problem are described below. • Agreement among Business Units • Two-Step Pricing • Profit Sharing • Two Sets of Prices

3.Agreement among Business Units
Some companies establish a formal mechanism whereby representative from the buying ad selling units meet periodically to decide on outside selling prices and the sharing of profits for products with significant upstream fixed costs and profit.

4.Two-Step Pricing
Includes two charges: 1. For each unit sold, a charge is made that is equal to the standard variable cost of production. 2. A periodic (usually monthly) charge is made that is equal to the fixed costs associated with the facilities reserved for the buying unit. One or both of these components should include a profit margin.

The transfer price of $11 per unit is a variable cost so far as Unit Y is concerned. However, the company’s variable cost for product A is $5 per unit. Thus, Unit Y does not have the right information to make appropriate short-term marketing decisions. If Unit Y knew the company’s variable costs, for example, it could safely take business at less than its normal price under certain conditions.

Two-step pricing correct this problem by transferring variable cost on a per-unit basis and transferred fixed cost and profit on a lump sum basis. Under this method, transfer price for product A would be $ 5 for each unit that Unit Y purchases, plus $20,000 per month for fixed cost, plus $10,000 per month for profit: $25,000 (5,000 units * $5 per unit)+ $30,000 for fixed costs + $10,000 for profit = a total of $55,000

• If transfers of product A in a certain month are at the expected amount of 5,000 units, under the two-step method Unit Y will pay the variable cost of $25,000 (5,000 units * $5 per unit), plus $30,000 for fixed costs and profit = a total of $55,000. This is the same amount it would pay Unit X if the transfer price were $11 per unit (5,000 * $11 = $55,000). • If transfer in another month were less – says, 4,000 units – Unit Y would pay $50,000 ([4,000 * $5] + $30,000) under the two-step method, compared with the $44,000 it would pay if the transfer price were $11 per unit (4,000 * $11). • The difference is its penalty for not using a portion of Unit X’s capacity that it has reserved. Conversely, Unit Y would pay less under the two-steps method if the transfer were more than 5,000 units in a given month. This represents the savings Unit X would have because it could produce the additional units without incurring additional fixed costs.

Points to consider about the two-step pricing method:
• The monthly charge for fixed costs and profit should be negotiated periodically. • Questions may be raised about the accuracy of the cost and investment allocation. • Under this pricing system, the manufacturing unit’s profit performance is not affected by the sales volume of the final unit. • There could be a conflict between the interests of the manufacturing unit and those of the company. • This method is similar to the “take or pay” pricing.

5. Profit Sharing
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-Variable Cost & marketing cost. Contribution = S.P – (V.C. + M.C.)

Problems of profit sharing system

over the way of dividing 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.

6.Two Sets of Prices
• In this method, the manufacturing unit’s revenue is credited at the outside sales and the buying unit is charged the total standard costs. • The difference is charged to a headquarters account and eliminated when the business units statements are consolidated.

Optional Use of Service
In some cases, management may decide that business units can choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all.

Administration of Transfer Prices
In this section we discuss how the selected transfer pricing policy should be implemented: • Negotiation • Arbitration & conflicts Resolution • Product classification

In most companies business units negotiate transfer prices with each other; that are transfer prices are not set by a central staff group. Perhaps the most important reason for this is the belief that establishing selling prices and arriving at satisfactory purchase prices are among the primary functions of line management. If headquarters control pricing, line management’s ability to affect profitability is reduced. Line managers should not spend an undue amount of time on transfer price negotiations.

Arbitration and Conflict Resolution
Arbitration, with a formal system, both parties submit a written case to the arbitrator. The arbitrator reviews their positions and decides on the price, sometimes with the assistance of other staff offices. There can be widely different degrees of formality in transfer price arbitration. • At one extreme, the responsibility for arbitrating disputes is assigned to a single executive – the financial vice president or executive vice president, for example – who talks to business unit managers, involved and then orally announces the price.

• The other extreme is to set up a committee. Usually such a committee will have three responsibilities: (1) setting transfer price disputes, (2) reviewing sourcing changes, and (3) changing the transfer price rules when appropriate.

Product Classification
Some companies divide products into two main classes: • Class I includes all products for which senior management wishes to control sourcing. These would normally be largevolume products; products for which no outside source exists. • Class II is all other products. Class II products are transferred a market prices.

• The sourcing of Class I products can be changed only by permission of central management. • The sourcing of Class II products is determined by the business units involved. Both the buying and the selling units are free to deal either inside o outside the company. Under this arrangement, management can concentrate on the sourcing and pricing of a relatively small number of high-volume products. Rules for transfer prices would be established using the various methods described in the preceding section, as appropriate.