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Transfer Pricing explained

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Transfer Pricing explained

ACCOUNTANCY
Asish K Bhattacharyya / New Delhi June 30, 2008, 0:39 IST

Transfer price 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 is a mechanism for distributing revenue between different divisions which jointly develop, manufacture and market products and services. Transfer pricing systems are designed to accomplish the following objectives: to provide each division with relevant information required to make optimal decisions for the organisation as a whole; to promote goal congruence that is, actions by divisional managers to optimise divisional performance should automatically optimise the firm's performance; and to facilitate measuring divisional performances. 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. Market-based transfer pricing system provides optimal results when the market for the intermediate product is perfectly competitive and the selling division can sell its output either to insiders or outsiders and as long as the buying division can obtain all its requirements from either outsiders or insiders. In such a situation the company as a whole has no additional cost of providing autonomy to divisions. For example, if division A decides to sell its product at the market price of Rs. 100 per unit and division B decides to buy the same product from market at the market price, net cash flow to the firm will be zero. If the market for the intermediate product is imperfect, this system may lead to sub-optimal utilisation of production capacity by the buying division. The transfer price will form an element of the total marginal cost and the buying division will restrict its output at the level where marginal cost = marginal revenue. Thus the firm as a whole will lose an opportunity to improve its profit because actual marginal cost is lower than the transfer price. For instance, the intermediate product that the sub-unit A of the firm uses is produced by the sub-unit B of the firm and another firm. The market price of the product is Rs 100 per unit, while the variable cost of production in division B is Rs 40 per unit. If, the transfer price is fixed at Rs 100 per unit (the market price) the sub-unit A will consider Rs 100 per unit as a part of its marginal cost. It will restrict the output at the level where marginal cost = marginal revenue. If the sub-unit B has excess capacity, the decision of the sub-unit A is sub-optimal for the firm as a whole. Even in a situation where the sub-unit B has no excess capacity, that is, it can sell its total output to outsiders at Rs 100 per unit, the decision of the sub-unit A to restrict its output at a level lower than its achievable capacity might be sub-optimal for the firm as a whole. Assume that the firm earns a contribution of Rs 100 per unit on the final product, the output of the sub-unit A. The contribution is higher than the contribution of Rs 60 per unit on the intermediate product. The firm loses the opportunity to earn higher profit by using the intermediate product internally in the sub-unit A in stead of selling the same to outsiders. If competitive prices are not available or it is too costly to obtain market prices, transfer prices may be determined based on the cost plus a profit. Cost-based transfer prices should be used only as a second option to market-based transfer prices because it involves complex calculations and results are less than satisfactory. Companies use variations of market-based and cost-based transfer pricing mechanisms to achieve the objective of goal congruence. Transfer-pricing system must have in-built mechanisms for smooth negotiation and conflict resolution. Although there is sound economic theory behind the selection of transfer pricing methods, companies use transfer price methods to achieve certain other objectives even at the cost of goal congruence. Often in family run businesses, decisions are taken at the group level. Therefore, decisions aim to optimise group performance. When group companies produce products that are used within the group, transfer price is established with an aim to optimise the group performance, although it may hurt the selling or the buying company within the group. An issue that is often ignored is that whether this practice undermines the interest of minority shareholders. If there is no minority shareholder in the company that is hurt, the ethical/corporate governance issue does not arise. Otherwise, this is an important issue and need to be addressed by the board of directors of individual companies. For multinational corporations, it may be advantageous to arbitrarily select prices such that most of the profit is made in a country with low taxes, thus shifting the profits to reduce overall taxes paid by a multinational group. However, most countries enforce tax laws based on the arm's length principle as defined in the OECD (Organisation for Economic Co-operation and Development) Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, limiting how transfer prices can be set and ensuring that that country gets to tax its "fair" share. In India, the OECD principle was adopted in 2001.

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the OECD principle was adopted in 2001.

Transfer Pricing explained

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Applying transfer pricing rules based on the arm's length principle is not easy, even with the help of the OECD's guidelines. It is not always possible and certainly takes valuable time to find comparable market transactions to set an acceptable transfer price. The revenue authority and the MNCs should work together in good faith to implement regulations effectively. The question of ethics cannot be ignored even in tax planning.

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Posted by: amruta modi

September 15 , 2011, 12:12 IST

can you please answer me whether transfer pricing is applied to associated enterprise if one enterprise provide after sales services to the client of other enterprise Posted by: papukutty
September 28 , 2009, 18:51 IST

Sir, I have aproblem to be soved. can u help me the question is TRANSFER PRIC ES AND DIVISIONAL PROFIT 1. A chair manufacturer has 2 divisions: framing and upholstering. The framing costs are $200 per chair and the upholstering costs are $300 per chair. The company makes $10,000 chairs each year, which are sold for $600. a. What is the profit of each division if the transfer price is $200? b. What is the profit of each division if the transfer price is $250? kindly answer to my email id thanking u truely kk papukutty

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