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Good Afternoon Friends Today Group 7 Presents Transfer Pricing

Batch XXI SMBA


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Index
Introduction - Transfer Pricing Objectives in Sound Transfer Pricing General Transfer-Pricing Rule Methods 1. Transfers based on the External Market Price 2. Cost Based (a) Variable Cost (b) Actual Full Cost (c) Full + Profit Margin (d) Standard Full Cost 3. Negotiated Prices 4. Dual Prices

Why MNCs use transfer pricing?

Transfer Pricing
y A transfer price is that notional value at which goods &

services are transferred between divisions in a decentralized organization. y Transfer Prices are normally set for intermediate products which are goods & services that are supplied by the selling division to the buying division. y In divisionalised companies, where profit or investment centers are created, there is likely to be inter-divisional transfer of goods or services and this internal transfer create the problem of transfer pricing.

Objectives in Sound Transfer Pricing


A question arises as to how the transfer of goods & services between divisions should be priced. The price charged to the interdivisional transfer of goods and services is revenues to the selling division & cost to the buying division. Therefore the price charged will affect the profit of both divisions; benefit (revenue) to one division can be created only at the expense of the other division. While determining transfer prices a number of criteria (objectives) should be fulfilled.
y Transfer prices should help in the accurate measurement of divisional performance

(Profitability) measurement.

y Transfer prices should motivate the divisional managers into maximizing the profitability of

their divisions and making decisions that are in the best interests of the organization as a whole.

y Transfer prices should ensure that divisional autonomy and authority is preserved. The main

purpose of decentralization is to enable divisional managers to exercise greater autonomy and to measure the overall results achieved on profit centre or investment centre. objectives of divisional managers are compatible with the objectives of overall company.

y Transfer prices should allow goal congruence to take place, which in effect means that the y A transfer pricing system, if properly established, can check multinational companies and

international groups which may try to manipulate transfer prices between countries in order to minimize the overall tax burden.

General Transfer-Pricing Rule


Managements' objective in setting a transfer price is to encourage goal congruence among the division managers involved in the transfer. The general Rule specifies the transfer price as the sum of two cost components. General Rule
outlay cost per unit incurred because goods are transferred Opportunity cost per unit to the organization because of the transfer

Transfer Price

First component Outlay cost


The first component is the outlay cost incurred by the division that produces the goods or services to be transferred. Outlay costs will include the direct variable costs of the product or service and any other outlay costs that are incurred only as a result of the transfer.

Second component Opportunity cost


The second component in the general Transfer-pricing rule is the opportunity cost incurred by the organization as a whole because of the transfer. An opportunity cost is a benefit that is forgone as a result of taking a particular action.

Illustration
Company
Sun coast Food Centers Company

Food Processing Division produces Bread in its Bakery

Gulf Division

Sells some of its products to other companies External Market Under different Labels

Atlantic Division

Scenario 1:No Excess Capacity


The following variable costs are incurred to produce bread and transport it to buyers. Per rack = 1 dozen bread packaged
Production: Standard variable cost per rack (including packaging) Transportation: Standard variable cost per rack to transport bread Rs. 7 per rack

Rs.1 per rack

Total outlay cost

Rs.8 per rack

Suppose the Food Processing Division can sell all the bread it can produce to outside buyers at a market price of Rs.15 per rack. Since the division can sell all of its production, it has no excess capacity.
Opportunity cost: Selling price per unit in External Market Less: Variable cost of production and Transportation Opportunity cost (forgone contribution margin)

Rs.15 per rack Rs.8 per rack

Rs.7 per rack

The Opportunity Cost incurred by Suncoast Food Centers when its Food Processing Division Transfers a rack of bread to the Gulf Division instead of selling it in the External Market is the forgone contribution margin from the lost sale, equal To Rs.7 per rack.

General Transfer Price Rule:


Outlay cost + Opportunity cost Rs.8 Rs. 7

Transfer Price

Rs.15

Why does the company lose a sale in the external market for every rack of bread Transferred to the Gulf Division? The sale is lost because there is no excess capacity in the Food Processing Division.

Goal Congruence
Contribution to Suncoast Food Centers from sale in External Market Wholesale selling price per rack Rs.15 per rack Contribution to Suncoast Food Centers from Transfer to Gulf Division Retail Selling Rs.24 per rack price per Rack (a loaf of bread Rs.2 x Rs.12 dozen = Rs.24) Less: Variable Rs.8 per rack costs

Less: Variable costs

Rs. 8 per rack

Contribution Margin

Rs.7 per rack

Contribution Margin

Rs.16 per rack

The best use of the bakery s limited production capacity is to produce bread for transfer to the Gulf Division.
Transfer Price Rs. 15 per rack

External Market Rs.15 per rack

[Goal congruence is maintained] The Gulf Division manager is willing to buy the bread, because her division will have a contribution margin Rs.9 on each rack of bread transferred. Rs.24 retail sales price

- Rs.15 Transfer price = Rs.9 per rack


rule result in goal congruent decision

The general transfer pricing making.

Scenario 2-Excess Capacity


Excess capacity means that the total demand for its bread from all sources, including the Gulf and Atlantic Divisions and the external market, is less than the bakery s production capacity.

Transfer Price = Outlay Cost + Opportunity Cost Rs.8 per rack =Rs.8 per rack + Rs.O per rack

Goal Congruence
Suppose a local organization makes a special offer to the Gulf Division Manager to buy several hundred Loaves of bread to sell in a promotional campaign. Gulf Division accept the special offer, this is in the best interests of Suncoast Food Centers. The company, as a whole, also will make a contribution of Rs.2 per rack on Every transfer red to the Gulf Division to satisfy the special order.

Special price per rack (special order) Less: Transfer price paid by Gulf Division

Rs.10 per rack Rs.8 per rack

Contribution to Gulf Division

Rs. 2 per rack

Once again, the general Transfer pricing rule maintains goal congruent decision making behavior.

Methods
Market Based Transfer Prices Cost Based Transfer Prices Negotiated Transfer Prices Dual Transfer Prices

External Market-Based Transfers Price


y If the transfer price is set at the market price, the

producing division should have the option of either producing goods for internal transfer or selling in the external market
y The buying division should be required to purchase

goods from inside its organization if the producing division s goods meet the product specifications
y Otherwise, the buying division should have an

option to buy from a supplier outside it s own organization

Market Based Prices


When the selling division does not have unused capacity (Total capacity 50,000 units) Rs. 20/unit Selling Division 50000 units Buying Division

50000 units

Rs. 20/unit

Rs. 20/unit

50000 units

External Buyer

External Supplier

Uses of External Market Based Transfer Pricing


y Encourages division managers to focus on divisional

profitability
y When aggregate divisional profits are determined for the

year, the market-based transfer price help to assess the contributions of each division to overall corporate profits

Example: Market Based Price


A company has 2 divisions, A and B. Division A manufactures a component which is used by Division B to produce a finished product. For the next period, output and costs have been budgeted as follow:
Division A Component units Finished units Total variable costs Fixed Costs Division B -

50,000
Rs. 2,50,000 Rs. 1,50,000

50,000
Rs. 6,00,000 Rs. 2,00,000

Please advise on the transfer price to be fixed for Division As component if it can sell the component in a competitive market for Rs. 10 per unit and Division B can also purchase the component from the open market at that price.

Example: Market Based Price


Solution: Transfer price = Incremental (marginal) cost + Opportunity cost of the company = Rs. 5 + Rs. 5 = Rs. 10 Hence, the transfer price of Rs. 10 is also equal to the to the market price of the component available at the same price.

Cost-Based Prices
y Used when external markets do not exist or

information about external market price not readily available

Variable Cost

ctual ull Cost Standard Cost

ull Cost Plus Profit Margin

Cost Based Prices: Variable Cost


When the selling division has unused capacity (Total capacity 50,000 units) Selling Division (unused capacity 20000 units) Rs. 10/unit (Variable cost) 20000 units Buying Division

30000 units

Rs. 20/unit

Rs. 20/unit

20000 units

External Buyer

External Supplier

Cost Based Prices:Actual Full Cost


Transfer Price = Full Cost of transferred product or service Full Cost = Variable Cost + allocated portion of fixed overhead
y Selling division no longer has any incentive to improve

its operating cost.

Cost-Based Prices: Full Cost plus Profit.


   

This method overcomes the weakness of Actual Full Cost method, wherein the selling division cannot realize a profit on goods and services. Under this method, the transfer price includes the full cost per unit (direct materials, direct labor and factory overhead) plus a mark up or profit allowance. Since, the selling division obtains profit contribution under this method, it benefits if performance is measured on the basis of divisional operating profits. However, the buying division of the organization would not really agree to such a type of transfer pricing as the cost of buying would rise and will adversely affect the performance of the buying division. Another challenge here is to determine the percentage of mark up (profit rate) which ideally should cover operating expenses and provide a target return on sales or assets (investment).

Cost-Based Prices: Full Cost plus Profit.


 Example: The total investments of division A in a company is Rs. 10,00,000. The volume of production is 4,00,000 units and the variable cost per unit is Rs. 10. The fixed cost of production is Rs. 8,00,000. The company desires 15% return on investment in Division A. What will be the transfer price for Division A.  Desired return on investment = 1,50,000 (15 % of 10,00,000) Volume of Production = 4,00,000 units Profit Margin/unit = 1,50,000/4,00,ooo = Rs 0.375

Cost-Based Prices: Full Cost plus Profit.


Amount (Rs.) Variable Cost per unit - A Fixed Cost per unit (8,00000/4,00,ooo) - Y Profit Margin per unit - Z Transfer price per unit (X+Y+Z) 10.00 2.00 0.375 12.375

Cost-Based Prices: Standard Costs


 As mentioned before, in actual cost approach, all product costs are transferred to buying division and hence, selling division is under no pressure of controlling costs.  This results in cost variances or cost inefficiencies in the selling division, which are thereby transferred to the buying division. To distinguish these variances that have been transferred to the buying division becomes extremely complex.  Hence, to eradicate this problem and to promote responsibility of cost control in the selling division, standard costs (decided costs) are usually used as basis of transfer pricing. It also helps increase efficiency in the selling division.  Use of standard costs reduces the risk to the buyer as it helps avoid being charged with supplier s cost overruns.

Negotiated Transfer Price


Negotiated prices are generally preferred as middle solution between market prices and cost-based prices. The Divisional Managers act the same as managers of independent organizations or companies. Negotiated transfer prices is likely to be close to external market prices (as explained earlier) when the Divisions are free to trade between each other as well as in the external markets. However, it will be less than market price when the Selling Division has an obligation of selling some of its total capacity to the Buying division (same concept as unused capacity). The objectives of goal congruence, autonomy and performance evaluation can be achieved if Selling and Buying divisions can agree upon a mutual transfer prices. However, this method requires a great deal of management efforts and the final negotiated price may depend on a Manager s ability and skill to negotiate rather than on the other factors.

Dual Transfer Pricing


Under this method, the Selling Division transfers goods at a profit (full cost
plus profit method) but the transfer price for the Buying Division is the market price. The difference in the transfer price for the two divisions is accounted for by a special centralized account. The balances in the centralized account are then accounted for against the total profit of the organization as a whole. The main motive of this kind of transfer pricing is to provide incentives to the Selling Division and also market price can be considered to be the most appropriate transfer price for the Buying Division. This helps in the overall goals of decentralization goal congruence, accurate performance management , autonomy and adequate motivation to divisional managers. However, such a method is rarely used in deciding the transfer prices for various division in the organizations.

Dual Transfer Pricing


Selling Division Buying Division

Centralized Account
Balance transferred

Organizational Profits

Why MNCs use Transfer Pricing?


Since each country has different tax rates, MNCs can increase their profits with the help of transfer pricing. By lowering prices in countries where tax rates are high and raising them in countries with a lower tax rate, MNCs can reduce their overall tax burden, thereby boosting their overall profits. That is why one often finds that corporations located in high-tax countries hardly pay any corporate taxes. Transfer pricing, a very controversial and complex issue, requires closure scrutiny not only by the critics of MNCs but also by the tax authorities in the developing world. Transfer pricing is a strategy frequently used by MNCs to obtain huge profits through illegal means. The transfer price could be purely arbitrary or fictitious, therefore different from the price that unrelated firms would have had to pay. By manipulating a few entries in the account books, MNCs are able to reap obscene profits with no actual change in the physical capital. For instance, a Korean firm manufacturers an MP3 player for $100, but its US subsidiary buys it for $199, and then sells it for $200. By doing this, the firm s bottom line does not change but the taxable profit in the US is drastically reduced. At a 30% tax rate, the firm s tax liability in the US would be just 30 cents instead of $30.

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