Module IV

Transfer Pricing

Objectives
To understand the concept of Transfer Pricing. To analyze the Transfer Pricing methods. To understand the problems of corporate services pricing. How is the administration of Transfer Pricing in the organization?

Transfer Pricing and its objectives

If two or more profit centers are jointly responsible for product development, manufacturing and marketing, each should share in the revenue generated when the product is finally sold. The transfer price is the mechanism for distributing this revenue. The transfer prices should be designed to accomplish different objectives like; - It should provide each business unit with the relevant information it needs to determine the optimum trade-off between company costs and revenue. - It should induce goal congruent decisions means the decisions which can improve business unit profit will also improve company profits. - It should help measure the economic performance of the individual business units. - The system should be simple to understand and easy to administer.

Transfer Pricing Principles and Mechanism

The transfer pricing issue is actually about pricing in general, modified slightly to take into account factors that are unique to internal transactions. 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. The ideal situation to implement the Transfer Pricing in the organization should have following components: - Competent People - Good Atmosphere - A Market Price - Freedom to source - Full Information - Negotiation

Contd.
Constraints on Sourcing: because of the corporate policies or other constraints it is not feasible to source for the purchase and sales department. - Limited Markets - Excess or shortage of industry capacity

Types of Transfer Pricing

1. The Profit Markup: In calculating the profit markup
there are two decisions: a) what the profit markup is based on and b) the level of profit allowed. the simple and most widely used base is percentage of costs. The amount of profit earned should not be high than the rate of return the independent business unit can earn if it sells the product outside. Agreement among business units: some companies establish a formal mechanism whereby representatives form selling and buying department meet periodically to decide on outside selling prices and the sharing of profits.

2.

Contd.
3. Two step pricing: first, for each unit sold, a charge is made that is
equal to the standard variable cost of production. And second, a periodic charge is made that is equal to the fixed costs associated with the facilities reserved for the buying unit.

4. Profit Sharing: if the two step pricing system is not feasible, a profit
sharing system can be used to ensure the congruence between a business unit and a company. This system can operate as follows: - the product is transferred to the marketing unit at standard variable cost. - After the product is sold, the business units share the contribution earned, which is the selling price minus the variable manufacturing and marketing costs.

Administration of Transfer Prices

i) After formulating the transfer pricing, the proper implementation is necessary. Specifically, the degree of negotiation allowed in setting transfer pricing methods of resolving transfer pricing conflicts And classification of products according to the appropriate method. Negotiation in most companies, the transfer prices are decided by the buying and selling department together and top management is not indulging into that as the profit responsibility are given to both the departments. The units negotiate with each other for the prices and earning the profit. Business units must be aware about the ground rules of the transfer prices which they need to follow. They can decide on their own about either source or to purchase/sale internally.

Contd.
ii) Arbitration and conflict resolution: - no matter how specific the prices are there may be situations where business units will not be able to agree on a price. - Thus, the arbitration is required and in company the financial vice president or executive vice president is taking this responsibility. They can talk to business unit and announce the prices. - The another method is to form a committee which will be taking the responsibilities like settling transfer pricing disputes, reviewing sources changes and changing the transfer prices rules when appropriate.

Contd.
iii) Product classification: - the extent and formality of the sourcing and transfer pricing rules depend to a large extent on the number of inter-company transfers and the availability of markets and market prices. - The organization can divide the products into different categories as per the sourcing decisions. If organization does not want the department to source outside for the secrecy level they can put control over it and vice a versa.