Chapter 6

Transfer Pricing

Concept of Transfer Pricing Objective of Transfer Pricing How transfer pricing influence goal congruence Methods of Transfer Pricing Situation of Limited Market and Excess or Shortage of Capacity Problems in pricing of corporate services by corporate staff to business units

Concept of Transfer Pricing

The transfer price is the price charged by one profit center of an organization for a product supplied to another business unit of the same organization. A price related to goods or services transferred from one process or department to another or from one member of a group to another.

Objectives of Transfer Pricing

Objectives of transfer pricing should be specified clearly before deciding to adopt a particular transfer pricing method for an organization. The main objectives of inter-company transfer pricing policy are as follows:

(1) To foster a commercial attitude in those who are responsible for the performance of profit centers. The main emphasis should be on profitability. It will force the units to improve their profit position. (2) To optimize the profit of the company over a gain period of time. For this purpose the resources should be utilized to the maximum extent. (3) To make optimum use of companys financial resources. It should be based on relative performance of various profit centers, which are influenced by transfer pricing polices. (4) To enable the performance of a division to be evaluated by compensating it for benefits provided for other division and changing it for benefits received by the division. (5) To motivate divisional manager for maximizing the profitability of their divisions acting in the best interest of the company as a whole. (6) To manage transfer price between countries in order to minimize overall tax burden by the international companies/groups.

How transfer pricing influences Goal Congruence

A market price- based transfer price will induce goal congruence if all the following condition exists. But it just suggests a way of looking and to improve the operation of transfer price mechanism. 1. Competent people Ideally manager should be interested in the long run as well as short run performance of their responsibility centers. Staff people involved in negotiation and arbitration of transfer prices also must be competent.

2. Good Atmosphere Managers must regard profitability, as measured in their income statements, an as important goal and a significant consideration in the judgment of their performance. They should perceive that the transfer price are just. 3. A Market Price The ideal transfer price is based on a well established, normal market price for the identical product being transferred that is, a market price reflecting the same conditions (quantity, delivery time, and quality) as the product to which the transfer price applies. The market price may be adjusted downward to reflect saving accruing to the selling unit from dealing inside the company. 4. Freedom to source Alternative for sourcing should exist and manager should be permitted to choose the alternative that is in their own best interests. The buying manger should be free to buy from the outside and the selling manager should be free to sell outside. In these circumstances, the transfer price policy simply gives the manager of each center the right to deal with either insider or outsider at his or her discretion. The market thus establishes the transfer price. The decision as to whether to deal inside or outside also is made by the marketplace. This method is optimum if the selling profit center can sell all of its product to either insider or outsider. The market price represents the opportunity cost to the seller of selling the product inside. This is because if the product were not sold inside, it would be sold outside. From the company point, the relevant cost of the product is the market price because that is the amount of cash that has been forgone by selling inside. The transfer price represents the opportunity cost to the company. 5. Full Information Manager must know about the available alternative and the relevant costs and revenue of each. 6. Negotiation There must be a smoothly working mechanism for negotiating contracts between business units. If all these condition are present, a transfer price system based on market prices would induce goal congruent decision, with no need for central administration.

Methods of Transfer Pricing

(I) (II) (III) (IV) (V) (VI) (I) Market Price Method Cost Based Method Two step pricing Method Profit Sharing Method Two Sets of price Method (Dual Pricing) Negotiated Method Market Price Method:

Under this method the transfer price is determined on the basis of well established, normal market price for similar product being transferred. The market price reflects reflects the same condition (delivery time, quality and the like) as the product to which the transfer price is applicable. Downward adjustment may be made to the market price to consider saving arising to the selling unit from dealing inside the company. For example, there would be lower advertisement, publicity, and selling expenses and no bad debts when there is transfer of products from one business unit to another. Merits:

(i) (ii)

Easily Available: Market prices are available with relative ease from published sources , suppliers etc., Measurement of Business Unit Performance: The market price is an impartial measure of overall efficiency of both the purchasing anf selling divisions.

(iii) (iv)

No need for central administration: there is no need for corporate headquarters to intervene in price fixation. This results in saving of precious time and money. Opportunity cost: The market price represent the opportunity cost of producing the product.

Demerits:

(i) (ii) (iii) (iv) (v) (II)

Problem of interpretation: The term market price is subject to a number of interpretations. It could be wholesale price index, ex-factory price, price to consumer etc. No market price fo intermediate and semi-finished products: it is possible that intermediate and semi- finished products may not be available in the market and as result it is impossible to get their market price. Inflation: During a period of inflation, market price tends to fluctuate frequently. Consequently, it would noe serve as a good guide in fixing transfer prices. Audit problem: market price includes a profit element and valuation of stocks using market price would lead to the inclusion of profit in closing stock. This would invite objections from statutory auditors. Additional cost: In the absence of ready availability of market information, additional costs have to be incurred to procure the same. Cost Based Method:

Transfer prices may be establish may be established on the basis of cost or cost plus a profit in case competitive prices are not available. Cost based transfer prices are widely used in USA, UK, Japan, Canada and India. The business unit must make two decisions in a cost based transfer price system:

1. How cost is to be defined? 2. How is the profit markup to be computed? 1. Actual Cost Basis: -

Under this method of transfer pricing, transfer price is arrived at on the basis of actual cost of production. While determining transfer price, firms excluded financing, advertising, bad debts and other expenses that the vendor not incurred in internal transections. Merits: As transfer price is based on actual cost, the selling business unit is in position to recoup the cost incurred. Demerits: The use of actual cost as transfer price will lead to the transfer of production inefficiencies to the purchasing profit center.

2. Standard cost basis : The standard cost of product is used for the purpose of fixing the transfer price. Standard cost is a scientifically predetermined cost based on management assessment and view of efficient operations and relevant expenditure. While determining transfer price, firms excluded financing, advertising, bad debts and other expenses that the vendor not incurred in internal transections. Merits: The standard cost basis is a sound method of establishing transfer price when market price is not available as production inefficiencies are not passed on to the purchasing unit.

Demerits:

The Vendor profit center may not possess the competence to fix transfer price. Inventories lying with the vendor and purchasing profit center at year end have to be adjusted to0 actual cost in order to prepare statutory annual accounts.

3. Cost plus mark up : This method of transfer pricing envisages the recovery of all costs plus a markup or allowances for profit. The profit performance of each unit can therefore be measured and it is possible to determine their efficiency with reasonable degree of accuracy. In so far as the base for calculating profit markup is concerned, the percentage of costs is one of them. It is simple to understand and easy to use and as a result it is widely used. However, it ignores the capital employed. Another method is percentage of investment. This method calculates s the profit markup based on the capital employed in manufacturing and selling the product. This is conceptually sound and superior to the percentage of cost method. The second design that needs to be made with the profit markup is the level of amount of profit. The profit allowances should be calculated on the investment necessary to produce the volume of products required by the purchasing profit centers. The calculation of investment required would be done at a standard level with inventories and fixed assets being valued at current replacement costs. Merits:

Profit is the main yardstick on the basis of which the efficiency of the management is judged. This facilitates interim comparisons as profit and return on investment are good indicators.

Demerits: The inclusion of profit elements in closing stock are not allowed by statutory auditors.

4. Profit Sharing Method : This is another method of Transfer Pricing where upstream fixed costs and profits are involved. Under this method, the product is transferred to the profit centre at standard variable cost. Once the product is sold, the contribution earned is shared by the business units. Advantages: (i) (ii) (iv) (v) (i) (ii) The profit of the company which is shared is real. It is easy to understand and calculate. It follows marginal costing analysis which is scientific accounting system. There is no competition between business unit. Argument over profit sharing of the business units will require top management to resolve disputes. It is costly and time consuming

(iii) It is fair to all business units.

Disadvantages:

(iii) It is against De-Centralization. (iv) It may affect autonomy of Business Unit Manager. (v) price. Allocation of profit does not give valid information on business unit profits. (vi) Manufacturing units profit depends upon the marketing units ability to sell and to sell at a proper

5. Two step pricing method:

The two step pricing method is another way to solve the problems arising from upstream fixed costs and profits. Under this, a charge is firstly made for each unit sold. This is equal to the standard variable cost of production. Secondly, a charge is made periodically that is equal to fixed costs of the facility reserved for the buying unit. A profit margin should be included in either of these components. Generally, a month is chosen as the period for the periodic charges. Example:

Business Unit X (Manufacturer) Expected monthly sales Variable cost per unit Monthly fixed cost Profit per unit

Product A 5000 units Rs.5 p.u Rs. 20000 Rs. 2

As per normal method of Full cost + profit transfer price would be Variable cost per unit + Fixed cost per unit + Profit per unit Transfer price Rs. 5 Rs. 4 Rs. 2 Rs. 11 x 5000 units = Rs. 55000

As per two step pricing method transfer price would be: Variable cost + Fixed cost + Profit Transfer price Rs. 25000 (5000x5) Rs. 20000 (5000x4) Rs. 10000 (5000x2) Rs. 55000

Now assume that units transferred in one month is 6000 Transfer price as per normal method = 6000 x 11 = 66000 As per step pricing Variable cost + Fixed cost + Profit Transfer price Rs. 30000 (6000x5) Rs. 20000 (We need to keep fixed cost same) Rs. 10000 (6000x2) Rs. 60000

6. Negotiated price method:

Under this method, periodical meetings between the representatives of the purchasing and vendors units are held to make decisions on external selling prices and on the sharing of profits in respect of products which have major amount of upstream fixed cost and profit. A firm could establish a formal mechanism for this purpose. The review should be conducted only in respect of decisions that involve a significant amount of business to atleast one of the profit centers. Merits It is an effective method of dealing with a situation where upstream fixed costs and profit are involved. Demerits It is possible that the review process may go beyond decisions relating to business of profit center and as a result it will cease to be workable.

7. Two sets of prices method:

This method envisages credit of manufacturing profit center revenue at the external sale price and purchasing profit center is charged the total standard cost in respect of the product transferred .the corporate headquarters account is charged with the difference during the consolidation of business unit statements the same is eliminated. The two sets of prices method is occasionally used when the frequency of conflict between the vendor and purchasing units cannot be settled by any other method. This method has a number of demerits it involves additional book keeping expenses as the account of corporate headquarters is debited everytime a transfer is made and again eliminated when the consolidation of business units statements takes place secondly this system gives the impression thet business units are earning money while it may be possible that the firm may be losing money after the considering debits made to corporate heatquatares account. Lastly by vitue of this system of transfer pricing business units may be motivated to lay more stress on internal transfer where the profit markup the profit markup is lucrative and ignore outside market sales.

Situation of Limited Market & Excess or Shortage of Capacity

Transfer price can be very simple or complex depending on the business. Ideally we need a proper negotiation system, a proper arbitration system, a proper conflict resolution system, a proper product classification system, competitive managers, good atmosphere, available market price, freedom to source and full information. All of these have to be present for a market price based transfer price system to induce goal congruence. Ideally, the buying and selling profit centre manager should be free to source but it may be unfeasible by company policy.

1.

Limited market:

Market for buying & selling profit centres may be limited due to: (i) The existence of internal capacity might limit the development of external sales. Most of the large companies in an industry are highly integrated hence production capacity for an intermediate product is limited. These profit centres can handle only a limited amount of demand. When internal capacity become tight, the market is flooded with demand for the intermediate product. Even though outside capacity exists it may be unavailable to the integrated company unless used on a regular basis or it may have trouble getting it externally when capacity is limited. (ii) If the company is a sole producer of a differential product then no external source exists. (iii) If a comaapy has invested in facilities, it is likely to use external sources, unless the external selling price is equal to variable cost which is unusual. Hence the produced products are captive. Integrated Oil companies send crude oil from the production unit to the refining unit even if there is an external market for the crude oil. Even in the case of limited markets, the best transfer price satisfying all requirement of a profit centre is the Competitive Price. If internal capacity is unavailable the company will buy from outside at the Competitive Price. The difference between the Competitive Price and the internal cost is money saved by producing rather than buying.

Methods of finding Competitive Price if there are no External Transaction (a) If published market prices are available they can be used to establish the TP, but these must be actual figures & consideration & consistent with TP for similar quantities i.e. if the company is producing in bulk, it should find the external wholesale market price instead of the retail price. (b) Market prices may be set by using Bids, only if the lowest bidder gets the business. Companies put out a bid for all products, but purchase only half of the product externally and produce the balance internally. (c) If the Buying Profit Centre purchases similar products from suppliers, it can duplicate the Competitive Price internally.

2.

Excess or Shortage of Capacity:

If the selling profit centre sells externally all of its production, i.e. it has excess capacity, which means there is a shortage of Demand in the industry, then the company may not optimize profits if the buying profit centre purchases from outside, in spite of the capacity being available internally. Conversely the selling profit centre will benefit by selling internally when the Buying Profit Centre cannot buy from outside because there is a shortage of supply in the industry. Here the output of the buying profit centre is restricted & company profit may not be optimum. Top management does not interfere, based on the theory that keeping the profit centre independent will set-off the loss from sub-optimizing companys profits. Selling profit centre appeals if buying profit centre continue to buy from outside even when capacity is available internally & buying profit centre appeals if selling profit centre continue to sell externally even when internal demand exists. Buying profit centre deal externally arguing that outsiders provide better service, which leads to rivalry in a decentralized company. Top management should be aware of the politics involved in TP Negotiations. Even is a constrains on sourcing exists, the market price is always best TP In every case, the transfer price would be the competitive price (market price). In other words, the profit center is appealing only the sourcing decision. It must accept the product at the market price.

Problems in pricing of corporate services by corporate staff to business units Capacity

There are some of the problems associated with charging business units for services furnished by corporate staff units. Central accounting, public relations, administration these are the costs of central service staff units over which business units have no control if these costs are charged at all, they are allocated, and the allocations do not include a profit component. The allocations are not transfer prices. There remain two types of transfers: 1. For central services that the receiving unit must accept but can at least partially control the amount used. 2. For central services that the business unit can decide whether or not to use. Control over amount of service Business units may be required to use company staffs for services such as information technology and research and development. In these situations, the business unit manager cannot control the efficiency with which these activities are performed but can control the amount of the service received. There are three schools of thought: One school holds that a business unit should pay the standard variable cost of the discretionary services. If it pays less than this, it will be motivated to use more of the service than is economically justified. On the other hand, if business unit managers are required to pay more than the variable cost, they might not elect to use certain cervices that senior management believes worthwhile from the companys viewpoint. This possibility is most likely when senior management introduces a new service, such as a new project analysis program. The low price is analogous to the introductory price that companies sometimes use for a new product. A second school of thought advocates a price equal to the standard variable cost plus a fare share of the standard fixed costs-that is, the full cost. Proponents argue that if the business units do not believe the services are worth at least this amount, something is wrong with either the quality or the efficiency of the service unit. Full costs represent the companys long run costs, and this is the amount that should be paid. A third school advocates a price that is equivalent to the market price or to standard full cost plus a profit margin. The market price would be used if available (e.g. costs charged by a computer service bureau); if not, the price would be full cost plus a return on investment. The rationale for this position is that the

capital employed by service units should earn a return just as the capital employed by manufacturing units does. Also, the business units would incur the investment if they provided their own service. Optional use of Services In some cases management may decide that business units can choose whether to use central service units. Business units may procure the service from outside, develop their own capability, or choose not to use the service at all. This type of arrangement is most often found for such activities as information technology, internal consulting groups, and maintenance work. These service centers are independent; they must stand on their own feet. If the internal services are not competitive with outside providers, the scope of their activity will be contracted of their services may be outsourced completely. Profit Centre Decentralization: Management style and culture influence concept of decentralized operation which top management chooses to run the organization. It is concerned with how control over divisional operations is exercised by top management through personal interactions, policies and procedures, including planning system. The chief executive of a company has to distribute the responsibility for profit earning among the top executives, keeping the control with him. In a big company with diversified products manufactured and distributed through number of units scattered over wide geographical locations-there is danger of responsibility for profit being diffused. Under functional structure, the management of profit becomes a very hard task and may even cut into the efficiency of the firm. Decentralization is surely an effective means to overcome this diffusion of profit responsibility.