Transfer Pricing 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? What is Transfer Price?: A transfer price is the price one subunit of an organization charges for a product or service supplied to another subunit of the same organization. The two segments can be cost centers, profit centers, or investment centers. For e ample, the allocation of service department costs to production departments that are set up as either cost centers or investment centers is an e ample of transfer pricing. Objectives of Transfer Pricing: (Why Transfer Pricing ?) !f two or more profit centers are "ointly responsible for product development, for e ample manufacturing and mar#eting, each should share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue. The transfer prices should be designed to accomplish different ob"ectives li#e$ !t should provide each business unit with the relevant information it needs to determine the optimum trade%off between company costs and revenue. !t should induce goal congruent decisions & means the decisions which can improve business unit profit will also improve company profits. !t should help measure the economic performance of the individual business units !t should motivate management effort !t should preserve a high level of subunit autonomy in decision ma#ing. The system should be simple to understand and easy to administer. Factors that are conducive for fixing an optimum Transfer Price: The ideal situation to implement the Transfer Pricing in the organization should have following components$ ' (ompetent People ' A *ar#et Price ' Full !nformation ' )ood atmostpher ' Freedom to source ' +egotiation Factors that are detrimenta : The determination of a fair Transfer Price may be adversely affected by constraints placed on sourcing either because of the corporate policies or due to certain constraints it is not feasible to source for the purchase and sales department. ,imited *ar#ets and - cess or shortage of industry capacity w ill also affect the determination of a fair transfer price. !ethods of determining Transfer Price: The three general methods for determining transfer prices are$
"# !ar$et%based transfer prices &# 'ost%based transfer prices (# )egotiated transfer prices

*ignificance of a ternative transfer%pricing methods: Alternative transfer%pricing methods can result in sizable differences in the reported operating income of divisions in different income ta "urisdictions. !f these "urisdictions have different ta rates or deductions, the net income of the company as a whole can be affected by the choice of the transfer%pricing method. !ar$et%based transfer prices: The transfer pricing issue is actually about pricing in general, modified slightly to ta#e into account factors that are uni.ue to internal transactions. For instance the transfer of an intermediate product between divisions.

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. This is what is referred to as the +arms ength, principle, to denote a distance that closely held firms or divisions with a firm should maintain in Pricing decisions. This is relevant in the matters of Ta ation especially with reference to *ultinational firms, which span across more than one country and thereby having ta implications involving several countries. Transferring products or services at mar#et prices generally leads to optimal decisions when /a0 the mar#et for the intermediate product mar#et is perfectly competitive, for instance the transferred product may have special characteristics that differentiate it from the products that are available in the mar#et. /b0 interdependencies of subunits are minimal, and /c0 there are no additional costs or benefits to the company as a whole from buying or selling in the e ternal mar#et instead of transacting internally. !inimum Transfer Price - .d e capacity: The general transfer%pricing guideline specifies that the minimum transfer price e.uals the additional outlay costs (Marginal Cost 0 per unit incurred up to the point of transfer plus the opportunity costs per unit to the supplying division. 1hen the supplying division has idle capacity, its opportunity costs are zero2 when the supplying division has no idle capacity, its opportunity costs are positive. Hence, the minimum transfer price will vary depending on whether the supplying division has idle capacity or not. 'ost%based transfer prices 3ometimes *ar#et prices are unavailable. -ven if the mar#et prices were available, it may be considered as being too costly an e ercise, to incorporate into a routine Pricing decision, and hence not feasible. 4nder such circumstances the alternatives of using cost based pricing is resorted to. 1hatever be the "ustification for the use of cost-based Transfer price, it will always be less satisfactory than the *ar#et Price. 4sually in this cost%based transfer pricing, the two issues that need to be resolved are$ i0 ii0 1hat costs are to be included ?/Full , 3tandard or *arginal costs ?0 and 1hat is the basis for the mar#%up? /is it an appro imation of outside mar#et price or one that is based on thecost of capital?0

Full Costs Plus Markup: 5ne potential limitation of full%cost%based transfer prices is that they can lead to suboptimal decisions for the company as a whole. An e ample of a conflict between divisional action and overall company profitability resulting from an inappropriate transfer%pricing policy is buying products or services outside the company when it is beneficial to overall company profitability to source them internally. This situation often arises where full% cost%based transfer prices are used. This situation can ma#e the fi ed costs of the supplying division appear to be variable costs of the purchasing division. Another limitation is that the supplying division may not have sufficient incentives to control costs if the full%cost%based transfer price uses actual costs rather than standard costs. The purchasing division sources e ternally if mar#et prices are lower than full costs. From the viewpoint of the company as a whole, the purchasing division should source from outside only if mar#et prices are less than variable costs of production, not full costs of production. Standard Costs: 4nder the full cost approach the supplying division could potentially pass on the inefficiencies of the division to the receiving division. !n order to overcome this limitation the use of 3tandard (osts is proposed. 3tandard osts are scientifically pre%determined cost of production. This control chec#s for the efficiency of the supplying division and motivates it to contain costs.

Marginal Costs Plus mark-up: 4nder this approach only the variable costs are considered on the contention that fi ed costs have already been sun# or committed irrespective of the receiving division6s purchase decision. !nasmuch as this does not allow the 3upplying 7ivision to recover its Fi ed (osts, it de%motivates the 3upplying 7ivision. This approach would however be valid if the supplying division has spare capacity that is lying idle for want of outside demand. )egotiated transfer prices: (ost and mar#et price information are often useful starting points in the negotiation process. (osts, particularly variable costs of the 8selling8 division, serve as a 8floor8 below which the selling division would be unwilling to sell. Prices that the 8buying8 division would pay to purchase products from the outside mar#et serves as a 8ceiling8 above which the buying division would be unwilling to buy. The price negotiated by the two divisions will, in general, have no specific relationship to either costs or prices. 9ut the negotiated price will generally fall between the variable costs%based floor and the mar#et price%based ceiling. T/o%*tep Pricing: 4nder this approach the transfer Price includes two charges. First for each unit sold , a charge is made that is e.ual to the standard variable cost of production. 3econd a periodic /4sually monthly0 charge is made that is e.ual to the fi ed cost associated with the facilities reserved for the buying unit. 5ne or both these components should include a profit margin. The scenario reproduced below illustrates the concept. . ustration 9usiness 4nit : / *anufacturer0 Product A - pected monthly sales to ; <=== 4nits >ariable (ost per 4nit ?s. < *onthly Fi ed (ost assigned to the product @=,=== !nvestment in wor#ing (apital A Facilities B@,==,=== (ompetitive return on !nvestment per year B=C 5ne way to transfer Product A to 9usiness 4nit ; is at a price per unit ,calculated as follows$ Transfer Price for Product 0 >ariable (ost per unit < P us: Fi ed (ost per 4nit D P us: Profit Per 4nit @E %%%%%%%%%%%%%%%%%%% Transfer Price Per 1nit 2s# "" %%%%%%%%%%%%%%%%%%% * ?5! per ;ear F B@,==,=== E B= C F B.@=,===. Annual Production F <=== unitsGP* E B@ F H=,=== Hence ?5! per 4nit F B,@=,===GH=,=== F .n this method the Transfer price of ?s. BB is a variable cost for 4nit ;. The (ompany6s >ariable cost, on the other hand is only ?s. <. Per unit. Thus 4nit does not have the right information to ma#e appropriate short% term mar#eting decisions. !f, for instance, unit ; #new that the (ompany6s variable cost was only ?s.<G unit, under certain circumstances, it could safely accept business at less than the its normal price. That is, as long as the price covers the variable cost and is contributing to the partial recovery of fi ed cost, though not resulting in profit. The two step pricing method correct this problem by transferring variable cost on a per unit basis, and transferring fi ed cost and profit on a lump sum basis.

4nder this method the transfer price for product A would be ?s.< for each unit that unit ; purchases plus ?s.@==== per month for fi ed cost. Plus ?s.B==== per month for profit$ !f transfer of product A in a certain month are at the e pected amount <=== units then under the two step method unit y will pay the variable cost of ?s.@<=== / <=== units E ?s.< per unit0 plus ?s.I==== ,on a monthly basis, for the fi ed cost and profit%%% a total of ?s.<<=== .This is the same amount as the amount it would pay unit if the Transfer Price were ?s.BB per unit / <=== EBBF ?s.<<,===0 if the transfers in another month is less than <=== units say D=== units, unit y would pay ?s.<=,=== J D=== units E ?s < K ?s I=,===L under the two step methods compared with the ?s.DD=== it would pay if the transfer price were ?s.BB per unit. The difference is their penalty for not using a portion of unit :6s capacity that it has reserved. (onversely, 4nit ; would pay less under the @ step%method if the transfers were more than <,=== units in a given month. This represents the savings 4nit : would have because it could produce the additional units without having to incur additional Fi ed (osts. +ote that under two step method the company variable cost for product A is identifiable to unit ;6s variable cost for the product, and unit ; will ma#e the correct short term mar#eting decisions. 4nit ; also has information on upstream fi ed costs and profit related to product A and it can use these data for long term decision. The fi ed cost calculation in the two step pricing method is based on the capacity that is reserved for the production of product A that is sold to unit ;. The investment represented by this capacity is allocated to product A. The return on investment that unit : earns on competitive / and, if possible comparable0 products is calculated and multiplied by the investment assigned to the product. !n the e ample we calculated the profit allowance as a fi ed monthly amount. !t would be appropriate under some circumstance to divide the investment into variable/ ?eceivable A !nventory0 and fi ed / Plant A *achinery0 components. Then, a profit allowance based on a return on investment on variable assets would be added to the standard variable cost for each unit sold. Following are some points to consider about the two%step pricing method: The *onthly charge for Fi ed (osts and Profit should be negotiated periodically and will depend on the capacity reserved for the buying unit. How much capacity to reserve for various products is an issue under this method of pricing 4nder this method the manufacturing units profit performance is not affected by the sales volume of the final unit. There could be a conflict of interest between manufacturing unit and those of the company. !f capacity is limited the unit may have an opportunity to increase its profit by using its limited capacity to cater to e ternal demand in preference to internal demand. This is mitigated by firm level involvement, by stipulating that the mar#eting unit has first claim. This method is similar to MTa#e or PayN pricing that is fre.uently used by public utilities, mining, pipelines and ,ong%term contracts

Profit sharing: !f the two step pricing system "ust described is not feasible, a profit sharing system might be used to ensure congruence of business unit interest with company interest. This system operates as follows. B. The product is transferred to the mar#eting unit at standard variable cost.

@. After the product is sold, the business units share the contribution earned which is selling price minus theCompanysvariable manufacturing and mar#eting costs. This method of pricing may be appropriate if the demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities as in the two step method. !n general, this method does ma#e the mar#eting unit6s interest congruent with that of the company. There are several practical problems in implementing such profit sharing system. First, there can be arguments over the way contribution is divided between the two profit centers. 3enior *anagement may have to intervene to settle the dispute. This is costly A time consuming and wor#s against a basic reason for decentralization, namely autonomy of the business units mangers. 3econd, arbitrarily dividing up the profits between units does not give valid information on the profitability of each unit. Third since the contribution is not allocated until after the sale has been made the manufacturing units contribution depends upon the mar#eting unit6s ability to sell and on the actual selling price. *anufacturing units may perceive this situation to be unfair T/o set of price: !n this method, the manufacturing unit6s revenue is credited at the outside sales price, and the buying unit is charged the total standard costs. The difference is charged to a head.uarter account and eliminated when the business unit statement are consolidated. This transfer pricing method is sometimes used when there are fre.uent conflicts between the buying and selling units that cannot be resolved by one of the other method. both the buying and selling units benefit under this method. There are several disadvantages to the system of having two set of transfer prices. First the sum of the business unit profits is greater than overall company profits. 3enior management must be aware of this situation when approving budgets for the business units and subse.uently evaluating performance against these budgets. 3econdly, this system create an illusive feeling that business units are ma#ing money while in fact the overall company might be losing after ta#ing account of the debits to head.uarters. Thirdly this system might motivate business unit to concentrate more on internal transfers at the e pense of outside sales. Fourthly, there is additional boo##eeping involved in first debiting head.uarters every time a transfer is made and then eliminating this account when the Financial 3tatements are consolidated. Finally the fact, that the conflict between the business units would be lessened under this system could be viewed as a wea#ness. 3ometime, it is better for the head.uarter to be aware of the conflict arising out of transfer prices because such conflict may signal problem in either the organizational structure or in other management systems. 4nder the two sets of prices method these conflicts are smoothed over thereby not alerting senior management to these problems. )umerica s: Output - sa es (a to externa customers) D=,=== tons *e ing price ?s.B@= per ton !argina cost (3 variab e cost) ?s.H< per ton Fixed 'osts ?s.O@=,=== PGA

The company also has a )lass 9ottles 7ivision, which needs B=,=== tons of molten glass per annum in order to manufacture its bottles. At present, however, the )lass 9ottles 7ivision buys all of its molten glass from an e ternal supplier at a price of ?s. B=< per ton. 7etermine the transfer Price in the following I scenarios *cenario ": No spare capacity in the Molten Glass Division *cenario &: Spare capacity in the Molten Glass Division and there is no demand from e ternal customers for these potential additional tons.

*cenario ($L M T!D Spare capacity in the Molten Glass Division 3uppose, for e ample, that the ma imum production capacity of the *olten )lass 7ivision is D<,=== tons per annum. 3ince there is demand from e ternal customers for D=,=== tons, this means that spare capacity is "ust <,=== tons. ?emember that the )lass 9ottles 7ivision needs B=,=== tons per annum *cenario 4:Assume that the transfer Price is based on the Full (ost *ethod *o ution: *cenario ": No spare capacity in the Molten Glass Division !f any tons of molten glass are sold to the )lass 9ottles 7ivision, then there will have to be a corresponding reduction in the .uantity sold to e ternal customers. Applying the commonly used principle, the *olten )lass 7ivision will want to set the transfer price as follows$ Plus 5ariab e cost of Production 'ontribution 8ost 3elling Price /%0 >ariable costs Production (osts !inimum TP3 67 B@= H< 77

%%%%%% "&9 PPPPPPPPPP *cenario &: *pare capacity in the !o ten : ass ;ivision And there is no demand from e ternal customers for these potential additional tons. This means that it is now possible to produce some e tra molten glass for sale to the )lass 9ottles 7ivision without any reduction in the .uantity sold to e ternal customers. in other words where spare capacity e ists, there is no opportunity cost associated with ma#ing the transfer. 5ariab e cost of Production 67 P us 'ontribution 8ost 3elling Price = >ariable costs$ = = Production (osts %%%%%% %%%%%%%%%%%%%%%%% !inimum TP3 67 %%%%%%%%%%%%%%%%% !n line with the principle of divisional autonomy, it is appropriate to leave it to the two division managers tonegotiate the precise transfer price within the range between H<A B=< *cenario (: 8.!.T<; *pare capacity in the !o ten : ass ;ivision 5nly half of 97Qs needs /<,=== tons0 can be produced using spare capacity, and these transferred tons should be priced in accordance with 3cenario @. As regards units which could not be produced using spare capacity, but would instead reduce the number of units available for sale to e ternal customers, in accordance with the logic of 3cenario B, the transfer price should be RB@= /the price charged to e ternal customers whom these transfers would displace0 *cenario 4: 0ssume that the transfer Price is based on the Fu 'ost !erthod Full (ost is calculated as follows$ !argina cost per ton (3 5'=ton) Fixed cost per ton Fu cost per ton ?s.H< ?s.BS /?sO@=,=== G D=,=== tons0 ?s.SI /?s.H< K ?s.BS0

!f we consider 3cenario B, it is clear that the full cost transfer price /RSI per ton0 would be too low where no spare capacity e ists. However, in 3cenario @ /where spare capacity e ists0 it is clear that the full cost transfer price of RSI per ton would lead to optimal decision%ma#ing in these circumstances /and, in fact, would split the incremental profit reasonably e.uitably between the two divisions. )umerica & 2e>uired ": !f 7ivision could sell B@<=== units T ?s B== each in the open mar#et%%%% 1hat Transfer Price the central *anagement would prefer in order to provide proper motivation to y 7ivision ? 2e>uired &: As *anagement Accountant would you advice 7ivision ; to 9uy the product at the Transfer Price determined in B above ? 2e>uired (: !f 3ales of 7ivision ;Qs product drops to ?s. @==, whether the TP of US will be acceptable ? 2e>uired 4: Assume that 7ivision : Qs product did not have an outside demand in e cess of one la#h units and its total Fi ed *anufacturing (osts could be reduced by B= C, if the >olume of the Production were reduced to B==,=== units, 1hat is the appropriate Transfer Price ? 2e>uired 7: 3uppose that : division Qs ma imum outside demand is B,B=,=== units at ?s. B== and there is no usage for the capacity . 1hat Transfer Price should the (ompany *anagement prefer? *o ution: 2e>uired ": !f 7ivision could sell B@<=== units T ?s B== each in the open mar#et%%%% *o n: 5ariab e cost of Production ?4 P us 'ontribution 8ost 3elling Price B== >ariable costs$ SD Production (osts 3elling (osts @ SH BD %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% *inimum TPF US %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% 2e>uired &: As *anagement Accountant would you advice 7ivision ; to 9uy the product at the Transfer Price determined in B above ? *o n: ;es, obviously the (ontribution earned by 7ivision ; would be more if the !nternal Transfer price is lesser than the e ternal purchase price. 2e>uired (: !f 3ales of 7ivision ;Qs product drops to ?s. @==, whether the TP of US will be acceptable ? *o n: 0pproach: - amine Perspective of ; 7ivision - amine Perspective of Firm B 1hether to Transfer to ; ? @ 1hether to sell the product of : e ternally ? Perspective of ;ivision @ ; Purchaes from : at TP US Contribution 3elling Price >ariable costs$

@==

Production (osts B== 9ought 5ut !tem US 3elling (osts H @=D %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% (ontribution /D.==0 %%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%% The (ontribution is +egative . 7ivision ; will be de%motivated Perspective of the Firm: The (ontribution earned by the firm when it sells the product of : e ternally is more than when it is transferred to ; and the final product is sold by ;. !f the firm is not strategically affected by this decision, it would be better to sell product of : e ternally, at least in the short term, till the time, the price of the product of 7ivision ; is sufficiently revived. 2e>uired 4: Assume that 7ivision : Qs product did not have an outside demand in e cess of one la#h units and its total Fi ed *anufacturing (osts could be reduced by B= C, if the >olume of the production were reduced to B==,=== units, 1hat is the appropriate Transfer Price ? *o n:2e>uired 7: 3uppose that : division Qs ma imum outside demand is B,B=,=== units at ?s. B== and there is no usage for the capacity . 1hat Transfer Price should the (ompany *anagement prefer ? *o n: For B=,=== units ?s US For B<=== units with +il 5pportunity (osts, the minimum Transfer Price will be?s.SD. The actual Transfer price, however, will be settled by negotiation, at a level above this minimum. 2eturn on .nvestment: V.B0 A0- plain the concept of ?5!. 1hat are its advantages? ?eturn on investment /?5!0 is the ratio of profit before ta to the gross investment. ?5! is calculated with the help of the following formula$ ?5! F /Pre%Ta ProfitG3ales0 : /3alesG+et Assets0 or /Pre%Ta ProfitsG+et Assets0 The numerator is profit before ta as reported in the PA, account. The profit should include only the profits arising out of the normal activities of the division. 4nusual items of receipts and e penses should be e cluded from the profit figure. 5ne should also ignore windfalls and income from investments not related to the operations of the division. Ta is e cluded from the numerator because the marginal of the 394 is not responsible for or in control of the ta paid. (apital employed can be ascertained from the balance sheet by including fi ed and current assets. Assets not currently put to divisional use should be e cluded from the investment base. 5ne also needs to e clude their relative earnings if any. The company should also e clude intangible assets li#e goodwill, deferred revenue e penses, preliminary e penses, etc. 2O. can be improved by: !ncreasing the profit margin on sales. !ncreasing the capital turnover !ncreasing both profit margin and capital turnover. ?educing cost as that adds to the total earnings of the firm. !ncreasing the profits by e panding present operations or developing new product line, increasing mar#et share, etc.

 7iversifying, introducing productivity imporevement measures, e pansion, replacement of old e.uipments Advantages of ?5! ?5! relates return to the level of investment and not sales as the rate of return is more realistic. ?5! can be decomposed into other variables as shown. These variables have tremendous analytical value. ?5! is an effective tool for inter%firm comparison. Vuestion B /b0$ !any experts regard <50 as a concept superior to 2O. and yet in certain casesA <50 does not do justice to the eva uation of investment center# <xp ain this phenomenon /ith as i ustration# ->A does not solve all the problems of measuring profitability in an investment center. !n particular, it does not solve the problem of accounting for fi ed assets discussed above unless annuity depreciation is also used, and this is rarely done in practice. !f gross boo# value is used, a business unit can increase its ->A by ta#ing actions contrary to the interests of the company, as shown in - hibit O%I. !f net boo# value is used, ->A will increase simply due to the passage of time. Furthermore, ->A will be temporarily depressed by new inWvestments because of the high net boo# value in the early years. ->A does solve the problem created by differing profit potentials. All business units, regardless of profitability, will be motivated to increase investments if the rate of return from a potential investment e ceeds the re.uired rate prescribed by the meaWsurement system. *oreover, some assets may be undervalued when they are capitalized, and others when they are e pensed. Although the purchase cost of fi ed assets is ordinarily capitalized, a substantial amount of investment in start% up costs, new product development, dealer organization, and so forth may be written off as e penses, and, therefore, not appear in the investment base. This situation applies especially in mar#eting units. !n these units the investment amount may be limited to inventories, receivables, and office furniture and e.uipment. 1hen a group of units with varying degrees of mar#eting responsibility are ran#ed, the unit with the relatively larger mar#eting operations will tend to have the highest ->A. !n view of all these problems, some companies have decided to e clude fi ed assets from the investment base. These companies ma#e an interest charge for controllable assets only, and they control fi ed assets by separate devices. (onWtrollable assets are, essentially, receivables and inventory. 9usiness unit manWagement can ma#e day%to%day decisions that affect the level of these assets. !f these decisions are wrong, serious conse.uences can occur%.uic#ly. For e amWple, if inventories are too high, unnecessary capital is tied up, and the ris# of obsolescence is increased2 whereas, if inventories are too low, production interWruptions or lost customer business can result from the stoc#outs. To focus attenWtion on these important controllable items, some companies, such as Vua#er 5ats, BO include a capital charge for the items as an element of cost in the busiWness unit income statement. This acts both to motivate business unit manageWment properly and also to measure the real cost of resources committed to these items. !nvestments in fi ed assets are controlled by the capital budgeting process before the fact and by post completion audits to determine whether the anticiWpated cash flows, in fact, materialized. This is far from being completely satis%factory because actual savings or revenues from a fi ed asset ac.uisition may not be identifiable. For e ample, if a new machine produces a variety of prodWucts, the cost accounting system usually will not identify the savings attributWable to each product. The argument for evaluating profits and capital investments separately is that this often is consistent with what senior management wants the business unit manager to accomplish2 namely, to obtain the ma imum long%run cash flow from the capital investments the business unit manager controls and to add capital investments only when they will provide a net return in e cess of the companyQs cost of funding that investment. !nvestment decisions, then, are controlled at the point where these decisions are made. (onse.uently, the capiWtal investment analysis procedure is of primary importance in investment conWtrol.

5nce the investment has been made, it is largely a sun# cost and should not influence future decisions. +evertheless, management wants to #now when capital investment decisions have been made incorrectly, not only because some action may be appropriate with respect to the person responsible for the mista#es but also because safeguards to prevent a recurrence may be appropriate.