Transfer pricing

Transfer Prices
● Transfer prices are the amounts charged by
one segment of an organization for a
product or service that it supplies to another
segment of the same organization.
Purpose of Transfer Pricing

Why do transfer-pricing systems exist?

– to communicate data that will lead to

goal-congruent decisions

– to evaluate segment performance and

thus motivate managers toward
goal-congruent decisions
Purpose of Transfer Pricing

Multinational companies use transfer

pricing to minimize their worldwide
taxes, duties, and tariffs.
Advantages and
disadvantages of basing
transfer prices on total
costs, variable costs,
and market prices.
 Transfers at Cost
● About half of the major companies in the
world transfer items at cost.
Transfers at Cost

What are some examples?

Full cost plus a profit markup
Variable costs
Standard costs
Actual costs
Full cost
 Market-Based Transfer Prices

If there is a competitive market for the product

or service being transferred internally, using
the market price as a transfer price will
generally lead to the desired goal
congruence and managerial effort.
 Market-Based Transfer Prices
● The major drawback to market-based prices
is that market prices are not always
available for items transferred internally.
 Variable-Cost Pricing
● When market prices cannot be used,
versions of “cost-plus-a-profit” are often
used as a fair substitute.
Variable-Cost Pricing

In situations where idle capacity exists,

variable cost would generally be the
better basis for transfer pricing and
would lead to the optimum decision
for the firm as a whole.
Negotiated Transfer Prices
● Companies heavily
committed to segment
autonomy often allow
managers to negotiate
transfer prices.
 Dysfunctional Behavior

Virtually any type of transfer pricing policy

can lead to dysfunctional behavior – actions
taken in conflict with organizational goals.
 The Need for Many Transfer
Prices
● The “correct” transfer price depends on the
economic and legal circumstances and the
decision at hand.
● Organizations may have to make trade-offs
between pricing for congruence and pricing
to spur managerial effort.
Factors affecting
Transfer prices.
 Multinational Transfer Pricing
Example
● An item is produced by Division A in a
country with a 25% income tax rate.
● It is transferred to Division B in a country
with a 50% income tax rate.
● An import duty equal to 20% of the price of
the item is assessed.
● Full unit cost is Rs100, and variable cost is
Rs60 (either transfer price could be chosen).
Multinational Transfer Pricing
Example

Which transfer price should be chosen?

Rs100 Why?
Multinational Transfer Pricing
Example

Income of A is Rs40 higher:

25% × 40 = (Rs10) higher taxes
Income of B is Rs40 lower:
50% × 40 = Rs20 lower taxes
Import duty paid by B:
20% × 40 = (Rs8)
∴ Net savings = Rs2
Global Pricing Considerations
Criteria while making Transfer pricing
decisions:

a) Tax regimes
b) Local Market conditions
c) Market Imperfections
d) Joint-venture partner
Key drivers behind transfer pricing
in Foreign Countries:

a) Market Conditions
b) Competition
c) Profit for the affiliate
d) Tax Rates
Key drivers behind transfer pricing
in Foreign Countries:
e) Economic conditions
f) Import Restrictions
g) Customs Duties
h) Price Controls
i) Exchange Controls
Setting Transfer Prices
a) Arm’s length prices:
use of market mechanism as a cue
for setting transfer prices.
b) Cost-based pricing (adds a mark-up)