Transfer pricing

Large companies , in practice, are often divisionalized, for having better control over them. Todays organizational thinking is towards decentralization. There is likely to be transfer of goods or services from one division to another OR between one profit center or investment center, to another profit center or investment center in the same division or company.. If two or more profit centers are jointly responsible for product development, manufacturing , and marketing, each share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue.

 Transfer price is the price at which the supplying division/ profit center / investment center PRICES ( charges) its transfer of output to the user entity. As it is only internal transfer and not a sale, transfer price is different from the normal sales price. The Transfer price charged is the revenue to the selling division / profit center /responsibility center AND cost to the buying entity. Thus, the price charged affects the profit of both, the selling as well as buying entity. In fact, the benefit ( revenue) to one division ( or profit center) can be created at the expense of the other division or profit center. The transfer pricing thus affects financial performance of different divisions / profit centers. Hence it should be free from all the biases, and has to be as equitable as possible to the different divisions / profit centers in the company concerned.

Some criteria for designing of transfer pricing system

Transfer price should help in accurate measurement of divisional or profit center economic performance. Transfer pricing should motivate the divisional/profit center managers into maximizing the profitability of their division / profit centers and make decisions which are in the best interest of the organization as a whole ( goal congruence business unit profit will also improve company profit). The transfer pricing system should ensure that divisional autonomy and authority is preserved &all relevant information to determine optimum trade offs between company costs and revenues provided. The system should be simple to understand and easy to administer. International groups may resort to manipulation of transfer pricing between countries with a view to minimize the overall tax burden.

 Two decisions are involved in designing a transfer price system.

First is the sourcing decision: should the company

produce the product inside the company or purchase it from outside?. Second is the transfer price decision : 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 following conditions exist in practice
Competent people Good atmosphere sense of fairness, judgment A market price : the market price could be adjusted downward to reflect savings accruing to the selling unit from dealing inside the company. For example saving in advertising and selling costs, fear of bad debt Freedom from source : managers should be permitted to choose alternatives that exist Full information : managers must know about the available alternatives and relative costs and revenues of each. Mechanism for negotiation

 Constraints on sourcing Limited Markets Excess or Shortage of Industry Capacity

 Several methods are used for transfer pricing. However, there are two basic approaches to determination of transfer price. They are : (i) Market based; (ii) Cost based.

Market Price
Most popular method of determining transfer pricing is the market price. When there is a well established market for the goods or services to be transferred, it can be easily determined on the market price basis. However, such market price should be taken as ceiling limit for transfer price. When transfer price is at market price, the profit center or divisional performances are more likely to represent the real economic contribution of the division to total company profit.

 Deviations may be allowed

Highly specialized products and ready market does not exist Consideration of advantage of economies of scale in production When consideration of taxation are applicable

Advantages of Market based transfer pricing

Most simple & easy to understand Minimizing the complication for performance evaluation Reduce points of conflict between various divisions

 Cost based Prices a) Variable Cost b) Actual Cost : transfer at full cost of production. However, it is quite appropriate for profit center analysis. c) Cost plus a normal mark-up : but can be arbitrary or questionable. d) Standard cost: encourages efficiency in selling division e) Opportunity Cost f) Negotiated price

 Dual prices Two step Prices

Cost based pricing

Cost plus profit Problems How to calculate the cost and the profit ? Actual cost or standard cost ? What about the fixed cost

Limitations
Negotiations has to happen in a fully informed environment

Example issues - determining transfer price

The Apparels division of Fortune Apparels uses yarn from Fortune Yarns, the spinning division, which is operating at full capacity. The yarns division sells part of its output to regular outside customers at Rs 15 per unit. Apparels division, which sells its products in the open market only, has offered Rs 10 per unit to the Yarn division & wants this to be transfer price . The cost structure of Apparel division is estimated as: Selling price Rs 100 Cost structure ( total cost) Rs 95
Outside supplies Fortune Yarn supplies Other variable costs Fixed overheads Rs 40 Rs 10* Rs 30 Rs 15

Estimated surplus per unit

Rs 5

 Apparel division is operating at about 50% of its capacity and the divisional management believes that a saving of Rs 5 per unit of yarn which is a major part of the Apparel divisions input, can give it a price advantage in the market and will be able to increase its capacity utilization if selling price is reduced by Rs 5 per unit. 1. Assuming that you are the divisional manager of Fortune Yarns, will agree to selling yarn at Rs10,000 to Apparel Division? Why or why not? 2. Can you evaluate the management issue involved in this situation? What will be your stand if you were the President of Fortune Company?

 The nature of Rs 15 per unit fixed cost is the key to the question of deciding what is good for Apparel division. These costs are to be incurred, irrespective of the volume of operations. Thus, even if the yarn in purchased at Rs 15 per unit and a price cut of Rs 5 is effect to increase the sales the contribution will still be positive as shown below: Selling price Rs 95 Less:
Outside supplies Fortune Yarns supplies Other Variable costs -Rs 40 - Rs 15 - Rs 30

Contribution margin

Rs 10

 The Apparel division has a positive contribution of Rs 10 per unit even after obtaining at the market price & effecting the required reduction in price to gain increased sales volume is still possible. Correct analysis will show that it is not necessary to obtain Rs5 relaxation from Yarn division to make a price reduction possible. Increased volume will in fact reduce per unit fixed cost.. The best interest of the Fortune company is served by the apparel division effecting a price cut to increase sales volume & thereby reduce per unit incidence of fixed costs. Forcing the Yarn division to supply at Rs 10 per unit is not a valid argument since there is no real advantage to the company as a whole.

 As the President of the company one would ask the Apparel division to look elsewhere for maximizing the margin rather than artificially increasing the same by temporary bail out by another division.

Transfer Pricing
Inter divisional/departmental pricing Fundamental principle Transfer pricing should be similar to the price that would be charged if the product were to be sold to outside customers or purchased from outside vendors

Profit sharing
Product is transferred to the buying unit at standard variable cost After the product is sold, the business units share the contribution earned

Limitations
How to divide the profits is a contentious issue Works against the principle of decentralization The individual department may blame each other for the inability to attain target

Two sets of pricing

Calculate the profit of Mfg unit based on the final selling price and the actual cost (excluding marketing cost) Calculate the profit of Selling unit based on standard production cost

Limitations
Sum of business unit profits are greater than the organizations profit. It may create problems in budgeting Company might be making losses while the individual business units make profits

Negotiation
Divisions fix transfer price through negotiations Full information should be available to all the department A well defined conflict resolution mechanism

Transfer pricing of services

Standard variable cost Problems - ICICI Bank Full cost Problems Railways Market price Problems SPIC SMO

Cash
Cash balances are lesser with Business Units They are only the float between daily receipts and daily disbursements Hence certain percentage sales is taken as cash balance Why include higher cash than balance? To compare with outside companies

Receivables
Managers can influence the level of accounts receivables Whether to include accounts receivable at selling price or at the cost of goods sold

Inventories
FIFO or LIFO Whether to deduct accounts payable from inventory

INVESTMENT CENTERS
Profits are related to Capital employed Business Unit OUTPUTS CAPITAL EMPLOYED (dollar profits)

INPUTS
(dollar costs)

Investment Centers
A special category of profit center where the manager is given authority to make investment decisions Measures Return of on Investment (ROI) EVA

Property, Plant and Equipment

Depreciation methods Disposition of Assets Leased Assets Idle assets Intangible assets