Transfer Pricing

MCS

University Questions on Transfer

Pricing
Q.1 a) Transfer Pricing is not an Accounting
tool. Comment with illustrations.
b) Market Price is ideal transfer price even
in limited markets. Comment.
Q.2. What are the objectives of transfer
pricing? What are the different methods
to arrive at transfer price? Discuss the
appropriateness of each method. Explain
with example.

University Questions on Transfer

Pricing
Q.3. When are the Market based Transfer
Prices most appropriate? How do we deal
with the condition of Limited Market,
situation of excess / shortage of
capacity?

Definition of Transfer Price

If two or more profit centers are jointly
responsible for product development,
manufacturing and marketing, each of these
centers should share in the revenue
generated when the product is finally sold.
Transfer price is the mechanism for
distribution of this revenue.

Objectives of Transfer Prices

1. It provides each business unit with relevant
information it needs to determine the optimum
trade off between company costs and revenues.
2. Should induce goal congruent decisions. The
system should be such that the increase in SBUs
profit should result in the increase of profits of
the company.
3. It should help measure the economic
performance of the SBU.
4. The system should be simple to understand and
easy to administer.

Transfer Pricing Methods

We need to discuss a few points before we go to
Transfer Pricing Methods:
Transfer price includes a portion of profit.
It is not the same as allocation of the costs.
It is not meant for merely accounting purpose,
but is also a behavioral tool. It helps manager to
take right decisions.
Transfer price mechanism is adopted to induce
responsibilities, which can be measured in terms
of profit/ profitability.

Transfer Pricing Methods

When the SBUs of a company buys and sells the
products from/ to one another the following two
aspects should be looked into:

Sourcing decision (should the company make

the product or outsource the requirement)

Transfer price decision (the price that the

buying unit should pay to the selling unit)

Transfer Pricing Methods

Limited markets:
1. The existence of internal capacity might limit
the development of the external sales.
2. If the company is the sole producer of a
differentiated product, no outside source exists.
3. If the company has invested significantly by
incurring fixed costs, it is unlikely to use outside
source unless the outside selling price
approaches the companys variable cost.

Transfer Pricing Methods

Excess or Shortage of Industry capacity:
Both the following situations are not allowed by the
company as it may not optimise the profits:
Selling SBU of the company sells the product in the
outside market because it has excess, while the
buying SBU buys the same product from the market
Buying SBU cannot obtain the product from outside
while the selling SBU is selling the same product
outside

Transfer Pricing Methods.

1. Market price
2. Competitive price
3. Cost-Based
1. Pricing by Agreement
2. Two Step

4. Profit Sharing
5. Two sets of Prices

Market price based transfer price

1.
2.
3.

4.

These conditions should be satisfied if market

based transfer price has to be adopted:
This method will induce goal congruence,
provided the following conditions exist.
SBU managers should be competent, i.e. they
are interested in short run as well as long run
performances
Managers should perceive TPs as just and be
interested in profitability as a goal.
Freedom to source the product from outside as
well as sell the product outside should be
permitted.

Market price based transfer price

5. The fundamental principle in determining the transfer
price is that the transfer price should be the same as the
price that would be charged if the product were sold to
outside customers or purchased from the outside
vendors.
6. Market price represents opportunity cost to the seller
(and also to the company)of selling the product inside
7. Managers ought to have full information about the
available alternatives, relevant costs and revenues of
each.
8. There must be smooth negotiation mechanism between
the SBUs

How is Market Price found?

Published market prices
Market price set by bids
If the production profit center sells the
similar product in outside markets
If the buying profit center buys the similar
product in outside markets

Other methods of setting transfer

price
Market price based TP requires the eight
conditions discussed before.
The following are the situations most of the
time:
freedom to sell to/ buy from the outside market
does not exist.
Markets for buying profit center and selling market
center may be limited.(slide no. 8).

And therefore the other methods of arriving at

transfer price are resorted to.

Competitive price as transfer price.

The following two types of situations arise:
The selling center may want its products to be
bought by the buying center, instead of the
buying center buying such products from outside.
The buying center may want selling center to sell
its product to it(i.e. buying center) instead of
selling center selling such products outside.

In such circumstances appeal can be made

against the sourcing decisions made by the
company

Competitive price as transfer price.

Under such circumstances arbitration process is set
up
The price fixed by the arbitration committee is the
competitive price
The arbitration generally lie against the sourcing
decision and not against the transfer price decision.
Competitive prices are generally near the market
prices, scaled downwards due to savings that will
accrue as no advertisements are required, no risk of
bad debts etc. it also does not contain the portion of
sales tax, cenvat etc.

Cost based Transfer Prices.

When the market based transfer price or the
competitive transfer price could not be
arrived, an attempt is made to calculate the
cost based transfer prices.
In the computation of the cost based transfer
price the attention is paid to the following
two points:
How to define cost
How to calculate profit mark up

Cost based Transfer Prices.

How to define costs?
The usual basis is standard cost

Actual costs are not used as it may pass the

production inefficiencies to the buying center
To use standard cost the company needs to
provide some incentive to set the tight standards
and to improve the standards

Cost based Transfer Prices.

(Two Step Transfer Pricing)
How to calculate profit mark up?

This decision is again based on two factors:

1. Basis for profit mark up ( generally base is
standard cost)
2. Level of profit allowed
1. As a percentage of the cost (in this case requirement
of capital is not considered)
2. As a percentage of the cost + consider some
percentage of investment
3. Profit mark up is near the rate of return that would
be earned, if the unit were an independent unit

Profit Sharing Method of Transfer Pricing

Selling department transfers the product to the
buying department at Standard Variable Cost.
After the product is sold, the contribution (i.e.
selling price minus variable manufacturing and
marketing costs) is shared by the business units.
This method divide the profit arbitrarily and
therefore two problems arise:
Serious disagreement among the SBUs as to how to
divide the profit
Accurate information is not available and the
efficiency of the unit can not be measured with
precision

Two sets of Prices Method of Transfer Pricing

In this method the manufacturing units revenue
is credited at the outside sales price
And the buying unit is charged the total
standard costs.
The difference is charged to HQ account and is
eliminated when the business units financial
statements are finalised.
This is not the fair way of setting transfer price.
The SBUs profitability can not be measured
properly in this system

Transfer Price for Corporate Services.

There are two types of corporate services (e.g. MIS,
R&D etc.):
Those the receiving unit must accept. However the
amount of service is at least partially controllable by the
unit.
Those type of services that the unit has the discretion of
using or not using.

Units should pay (one of the following as transfer

price):
the Standard Unit Costs
Standard Unit Cost + a portion of Fixed Cost
Market Price.