TRANSFER PRICING

CHAPTER 6
 OBJECTIVES
• To understand the concept of Transfer
Pricing.
• To analyze the Transfer Pricing methods.
• To understand the problems of
corporate services pricing.
• How is the administration of Transfer
Pricing in the organization?
 TRANSFER PRICING MEANING
• Transfer Price is the price one subunit charges
for a product or service supplied to another
subunit of the same organization.
• Transfer Pricing is a mechanism for
DISTRIBUTING THE REVENUE.
• It is a value placed on a transfer of goods or
services in transactions in which at least one
of the two parties involved is a profit center.
 Cont…
• If two or more profit centers are jointly
responsible for product development,
manufacturing and marketing, each should
share in the revenue generated when the
product is finally sold.
• Transfer price includes a profit element
because an independent company normally
would not transfer goods or services to
another independent company at cost or less.
• A transfer price is what one part of a
company charges another part of the
same company for goods or services.
• Hence, the transfer price is the price
that the “selling” division charges the
“buying” division for the product. 
 TRANSFER PRICING : OBJECTIVES
It should provide each business unit with the
relevant information it needs to determine the
optimum trade-off between company costs and
revenue.
It should induce goal congruent decisions –
means the decisions which can improve business
unit profit will also improve company profits.
It should help measure the economic
performance of the individual business units.
The system should be simple to understand and
easy to administer.
 Cont….
• 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.
• 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.
 FUNDAMENTAL PRINCIPLE
• 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.
• When profit center of a company buy products from,
and sell to, one another, two decision must be made.
 Sourcing Decision (produce the product or purchase)
 Transfer Price Decision (produce inside what price
should transfer)
 THE IDEAL SITUATION
• The ideal situation to implement the Transfer
Pricing in the organization should have
following components:
 Competent People
 A Market Price
 Freedom to source
 Full Information
 Negotiation
 Manager should interested in the long-run as well
as in the short-run performance of their business
unit. They must be competent people for the
negotiation of transfer price.
 The ideal transfer price is based on a well-
establish, normal market price for product being
transferred.
 Alternatives for sourcing should exist, and
manager should permitted to choose the
alternative that is in their own best interest. The
buying manager should be free to buy from the
outside and the selling manager should be free to
sell outside.
 Manager must know about the available
alternatives and the relevant costs and
revenues of each.
 There must be smoothly working mechanism
for negotiating “contracts” between business
units.
 If all these condition are present, a transfer
price system based on market price would
induce goal congruent decisions, with no need
for central administration.
 Transfer Pricing Options
• There are three general methods for
establishing transfer pricing.
 Market-based Transfer Price
 Cost-based Transfer Price
 Negotiated Transfer Price
 Market-based Transfer Price
• In the presence of the competitive and stable external
markets for the transferred product, many firms use
the external market price as the transfer price.
• The upstream division is generally indifferent between
receiving the market price from an external customer
and receiving the same price from an internal customer.
• If the downstream division is willing to do so, the
implication is that the downstream division can
generate incremental profits for the company by
purchasing product from the upstream division.
 Cost-based Transfer Price
• The transfer price is based on the production
cost of the upstream division. A cost-based
transfer requires that the following criteria be
specified:
 Actual cost or budgeted cost
 Full cost or variable cost
 The amount of markup, if any, to allow the
upstream division to earn a profit on the
transferred product.
 Negotiated Transfer Price

• Senior management does not specify the

transfer price. Rather, divisional managers
negotiated a mutually-agreeable price.
 The Profit Markup
1. In calculating the profit markup there are
two decisions: a) what the profit markup is
based on and b) the level of profit allowed.
- the simple and most widely used base is
percentage of costs.
- The amount of profit earned should not be
high than the rate of return the independent
business unit can earn if it sells the product
outside.
Agreement Among Business Units
• some companies establish a formal mechanism
whereby representatives form selling and
buying department meet periodically to decide
on outside selling prices and the sharing of
profits.
• The units negotiate with each other for the
prices and earning the profit. Business units
must be aware about the ground rules of the
transfer prices which they need to follow.
 Administration of Transfer Prices
 Arbitration and conflict resolution:
- no matter how specific the prices are there may be
situations where business units will not be able to agree
on a price.
- Thus, the arbitration is required and in company the
financial vice president or executive vice president is
taking this responsibility. They can talk to business unit
and announce the prices.
- The another method is to form a committee which will be
taking the responsibilities like settling transfer pricing
disputes, reviewing sources changes and changing the
transfer prices rules when appropriate.
Thank you