- Cost planning
- Cost Analysis
- Cost management Techniques
- Externally oriented Cost Management Techniques
- Relevant costs
- Short term decisions
- Risk and Uncertainty
- Linear programming – graphical method
- Linear programming the simplex method
- Multi Product CVP Analysis
- Pricing decisions and Pricing strategies
- Budgetary Control
- Performance Evaluation
- Measuring performance in divisionalised businesses
- Transfer pricing
A transfer price is the ‘Price at which goods or services are transferred between different units of the same company’. These transfer pricing notes are prepared by mindmaplab team and covering introduction to transfer pricing, transfer costs, international transfer pricing, market-based transfer pricing, cost-based transfer pricing, the minimum transfer pricing and methods of transfer pricing management. transfer pricing short note are also available in pdf version too download.
The basic principles of transfer pricing
A transfer price is the ‘Price at which goods or services are transferred between different units of the same company’.
When a company has a divisionalised structure, some of the divisions might supply goods or services to other divisions in the same company.
- One division sells the goods or services. This will be referred to as the ‘selling division’.
- Another division buys the goods or services. This will be referred to as the ‘buying division’.
For accounting purposes, these internal transfers of goods or services are given a value. Transfers could be recorded at cost. However, when the selling division is a profit centre or investment centre, it will expect to make some profit on the sale.
Therefore, there will be two sources of revenue.
- External sales revenue from sales made to other organisations
- Internal sales revenue from sales made to other responsibility centres within the same organisation, valued at the transfer price
Internal sales are referred to as transfers, so the internal selling and buying price is the transfer price. A decision has to be made about what the transfer price should be. A transfer price may be:
- the cost of the item (to the selling division), or
- a price that is higher than the cost to the selling division, which may be cost plus a profit margin or related to the external market price of the item transferred.
Transfer prices should be set at a level which ensures that profits for the organisation as a whole are maximised.
Main uses/objectives of transfer prices
The decisions made by each profit centre manager should be consistent with the objectives of the organisation as a whole, i.e. the transfer price should assist in maximising overall company profits.
The buying and selling divisions will be treated as profit centres. The transfer price should allow the performance of each division to be assessed fairly. Divisional managers will be demotivated if this is not achieved.
Transfer prices are particularly appropriate for profit centres because if one profit centre does work for another, the size of the transfer price will affect the costs of one profit centre and the revenues of another. The system used to set transfer prices should seek to maintain the autonomy of profit centre managers. If autonomy is maintained, managers tend to be more highly motivated but sub-optimal decisions may be made.
Recording the movement of goods and services
In practice, an extremely important function of the transfer pricing system is simply to assist in recording the movement of goods and services.
The ideal solution
Ideally a transfer price should be set at a level that overcomes these problems:
- The transfer price should provide an ‘artificial’ selling price that enables the transferring division to earn a return for its efforts, and the receiving division to incur a cost for benefits received.
- The transfer price should be set at a level that enables profit centre performance to be measured ‘commercially’. This means that the transfer price should be a fair commercial price.
- The transfer price, if possible, should encourage profit centre managers to agree on the amount of goods and services to be transferred, which will also be at a level that is consistent with the aims of the organisation as a whole, such as maximising company profits.
The general rules highlight the boundaries within which transfer prices should fall to make them acceptable to both the supplying and receiving divisions. The limits within which transfer prices should fall are as follows:
- The Minimum Price:
The sum of the supplying division’s marginal cost and opportunity cost of the item transferred.
The minimum results from the fact that the supplying division will not agree to transfer if the transfer price is less than the marginal cost + opportunity cost of the item transferred (because if it were, the division would incur a loss).
- The Maximum Price:
The lowest market price at which the receiving division could purchase the goods or services externally, less any internal cost savings in packaging and delivery.
The maximum results from the fact that the receiving division will buy the item at the cheapest price possible.
The opportunity cost included in determining the lower limit will be one of the following:
- The maximum contribution forgone by the supplying division in transferring internally rather than selling goods externally.
- The contribution forgone by not using the same facilities in the producing division for their next best alternative use.
If there is no external market for the item being transferred, and no alternative uses for the division’s facilities, the transfer price = standard variable cost of production.
If there is an external market for the item being transferred and no alternative, more profitable use for the facilities in that division, the transfer price = the market price.
Setting the transfer price
In broad terms, there are three bases for setting a transfer price:
- Market based prices
- Cost based prices
- Negotiated prices
I. The use of Market Price as a basis for transfer prices
It is more realistic to set the transfer price at or close to a market price for the item transferred, but this is only possible if an external market exists for the item. If an external market exists for the product being transferred (and there is unsatisfied demand externally), the ideal transfer price will be the market price.
*If variable costs and market prices are constant, regardless of the volume of output, a market-based transfer price is the ideal transfer price.
*If a perfect external market exists, market price is the ideal transfer price.
The external market is also sometimes known as the intermediate market.
Adjusted market price
Internal transfers are often cheaper than external sales, with savings in selling and administration costs, bad debt risks and possibly transport/delivery costs. It would therefore seem reasonable for the buying division to expect a discount on the external market price.
Advantages of this method:
- The transfer price should be deemed to be fair by the managers of the buying and selling divisions. The selling division will receive the same amount for any internal or external sales. The buying division will pay the same for goods if they buy them internally or externally.
- The company’s performance will not be impacted negatively by the transfer price because the transfer price is the same as the external market price.
Disadvantages of this method:
- There may not be an external market price.
- The external market price may not be stable. For example, discounts may be offered to certain customers or for bulk orders.
- Savings may be made from transferring the goods internally. For example, delivery costs will be saved. These savings should ideally be deducted from the external market price before a transfer price is set, giving an “adjusted market price”.
II. Transfer prices based on Full cost
A cost-based transfer price could be:
- the marginal cost to the selling division of making the product or providing the service
- the selling division’s marginal cost plus a mark-up for profit
- the full cost to the selling division of making the product, or
- the selling division’s full cost plus a markup for profit.
Under this approach, unsurprisingly, the full cost (including fixed production overheads absorbed) that has been incurred by the supplying division in making the intermediate product is charged to the receiving division. If a full cost-plus approach is used, a profit margin is also included in this transfer price.
The transfer price fails on all three criteria (divisional autonomy, performance measurement and corporate profit measurement) for judgement.
Transfer prices based on Variable or marginal cost
A variable or marginal cost approach entails charging the variable cost that has been incurred by the supplying division to the receiving division.
One of the problems with a variable cost approach to transfer pricing is that the selling division will not cover its fixed costs. Dual pricing, results in different prices being used by the selling and buying divisions.
The selling division will use a price that will allow it to report a reasonable profit (usually the external market price if there is one). The buying division will be charged with the variable cost.
The difference between the two prices will be debited to a group account which will then be cancelled out when divisional results are consolidated to arrive at the group profit.
If transfer prices are set at variable cost with an imperfect external market, the supplying division does not cover its fixed costs. Dual pricing or a two-part tariff system can be used in an attempt to overcome this problem.
Two-part tariff system
A two-part tariff system can be used to ensure that the selling division’s fixed costs are covered. Transfer prices are set at variable cost and once a year there is a transfer of a fixed fee as a lump sum payment to the supplying division, representing an allowance for its fixed costs.
This method risks sending the message to the supplying division that it need not control its fixed costs, however, because the company will subsidise any inefficiencies.
III. Negotiating a transfer price
Negotiation might be a method of identifying the ideal transfer price in situations where an external intermediate market does not exist. A negotiated transfer price is a price that is negotiated between the managers of the profit centres.
A transfer price based on opportunity cost is often difficult to identify, for lack of suitable information about costs and revenues in individual divisions.
In this case it is likely that transfer prices will be set by means of negotiation. If divisional managers are allowed to negotiate transfer prices with each other, the agreed price may be finalised from a mixture of accounting arithmetic, negotiation and compromise.
- A negotiated price might be based on market value, but with some reductions to allow for the internal nature of the transaction, which saves external selling and distribution costs.
- Where one division receives near-finished goods from another, a negotiated price might be based on the market value of the end product, minus an amount for the finishing work in the receiving division.
Disadvantages of negotiation are as follows:
- The divisional managers might be unable to reach agreement. When this happens, management from head office will have to act as judge or arbitrator in the case.
- The transfer prices that are negotiated might not be fair, but a reflection of the bargaining strength or bargaining skills of each divisional manager.
Transfer pricing when there is no external market for the transferred item
There may be instances when there is no external market for the item being transferred. The question arises as how to set an appropriate transfer price in such circumstances.
When there is no external market for the item being transferred, the transfer price should be greater than or equal to the variable cost in the supplying division, but less than or equal to the selling price minus variable costs (net marginal revenue) in the receiving division.
If there is no similar item sold on an external market, and if the transferred item is a major product of the transferring division, there is a strong argument that profit centre accounting is a waste of time. It would be more appropriate, perhaps, to treat the transferring division as a cost centre, and to judge performance on the basis of cost variances.
If profit centres are established, in the absence of a market price, the optimum transfer price is likely to be one based on standard cost plus, but only provided that the variable cost per unit and selling price per unit are unchanged at all levels of output. A standard cost plus price would motivate divisional managers to increase output and to reduce expenditure levels.
Transfer pricing and changing costs/prices
No external market for the transferred item
When there is no external market for the transferred item and changing costs/prices for the final output, the transfer price should be greater than or equal to the marginal cost in the supplying division, but less than or equal to the net marginal revenue in the receiving division.
If cost behaviour patterns change and the selling price to the external market (for the receiving division’s product) is reduced at higher levels of output, there will be a profit-maximising level of output: to produce more than an ‘optimum’ amount would cause reductions in profitability.
Under such circumstances, the ideal transfer price is one which would motivate profit centre managers to produce at the optimum level of output, and neither below nor above this level.
With an external market for the transferred item
Where there is an imperfect external market for the transferred item and changing costs/prices for the final output, the transfer price should again fall between marginal cost in the supplying division and net marginal revenue in the receiving division.
The approach is essentially the same as ‘No external market for the transferred item’, except that the supplying division may also have income, and so its marginal revenue needs to be taken into account.
Maximising profits when the transferred item is in short supply
Where there is a capacity constraint resulting in short supplies of the product, a transfer price based on matching marginal cost and marginal revenue will not encourage corporate profit maximisation.
Profit maximisation with a perfect external market
When there is a perfect external market for the transferred item and changing costs/prices for the final output, profits are maximised when market price is used on the transfer price.
Identifying the optimal transfer price
How to determine ideal transfer price?
There are various rules involved in the determination of the optimal transfer price:
- The ideal transfer price should reflect the opportunity cost of sale to the supply division and the opportunity cost to the buying division.
- Where a perfect external market price exists and unit variable costs and unit selling prices are constant, the opportunity cost of transfer will be external market price or external market price less savings in selling costs.
- In the absence of a perfect external market price for the transferred item, but when unit variable costs are constant, and the sales price per unit of the end product is constant, the ideal transfer price should reflect the opportunity cost of the resources consumed by the supply division to make and supply the item and so should be at standard variable cost + opportunity cost of making the transfer.
- When unit variable costs and/or unit selling prices are not constant, there will be a profit- maximising level of output and the ideal transfer price will only be found by sensible negotiation and careful analysis.
There may be a range of prices within which both profit centres can agree on the output level that would maximise their individual profits and the profits of the company as a whole. Any price within the range would then be ‘ideal’.
International Transfer Pricing
Transfers within an international group will often be cross-border, between divisions in different countries. With international transfers and international transfer pricing, certain factors need to be considered.
Different tax rates
A multinational company will seek to minimise the group’s total tax liability. One way of doing this might be to use transfer pricing to:
- reduce the profitability of its subsidiaries in high-tax countries, and
- increase the profitability of its subsidiaries in low-tax countries.
Changes in the transfer price can redistribute the pre-tax profit between subsidiaries, but the total pre-tax profit will be the same. However, if more pre-tax profit is earned in low-tax countries and less profit is earned in high-tax countries, the total tax bill will be reduced.
Groups of corporations around the world park their profit in subsidiaries which operate in jurisdictions with low tax rates and park their losses jurisdictions with high tax rates in order to increase net benefits.
Governments around the world try to address this issue with special rules for pricing of cross border sales of goods.
It is also possible, that some countries wishing to attract business might have tax laws that are very favourable to business. A country with the status of a ‘tax haven’ might offer:
- a low rate of tax on profits
- a low withholding tax on dividends paid to foreign holding companies
- tax treaties with other countries
- no exchange controls
- a stable economy
- good communications with the rest of the world
- a well-developed legal framework, within which company rights are protected.
Multinationals might set up subsidiary companies in tax havens, trade through these companies, and hope to reduce their total tax liabilities.
Transfer Pricing to manage cash flow
Some governments might place legal restrictions on dividend payments by companies to foreign parent companies.
In this situation, it would be tempting for a multinational to sell goods or services to a subsidiary in the country concerned from other divisions in other countries, and charge very high transfer prices as a means of getting cash out of the country.
International Transfer pricing and currency management
When inter-divisional transfers are between subsidiaries in different countries or currency zones, a decision has to be made about the currency to select for transfer pricing.
Exchange rates, even for strong currencies, can be very volatile and subsidiaries could make unexpected profits or losses from movements in an exchange rate.