Presented By:-

Group 9
 TRANSFER PRICING

 Transfer price is the price which one unit of the

organization charges for a product or service
supplied to another sub-unit of the same
organization.
 The transfer price used in the organization will have
significant effect on the financial performance of
different divisions.
 Transfer pricing has a significant bearing on the
revenues, costs and profits of responsibility centres.
Transfer Pricing Objectives

Divisonal
Autonomy

Optimal
Performance
Resource
Assessment
Allocation

OBJECTIVES

Organisational Divisonal
Goal Managerial
Congruence Motivation
 Requirements of Transfer Price:-

 Transfer price should be objectively determinable.

 It should be equal to the value of the intermediate
products being transferred. The transfer price should
compensate the transferring division and charge the
buying division for the value of the product exchanged.
 It should be compatible with the policy that
maximizes attainment of a company's goal and
evaluation of segment performance.
 The limits within which the transfer price should
fall are:-

# Minimum: The sum of selling division's marginal cost and the

opportunity cost of resources used.
# Maximum: The lowest market price at which the buying
division could acquire the goods or services externally, less
any internal cost savings in packaging and delivery.

Profit: The difference between the two limits represents the

savings made by producing internally as opposed to buying it
from outside.
Types of transfer pricing

Methods of Fixing
Transfer Prices

Cost Based Market Based Negotiated

Cost plus Prevailing

Cost Price Standard Cost Normal Incremental Market Approximation Bidding
markup Price
 Company’s O.P. remains same irrespective of the method used

Market Price Cost Basis Negotiated

1. Production Divison(S.P./gallon) $ 13 $ 8.8=1.1*8 $ 10

Revenue $1300 $880 $100

(V.C.-$2/gallon) $200 $200 $200

(F.C.) $600 $600 $600

O.P. $500 Rank 1 $80 Rank 3 $200 Rank 3

2.Transportation Divison(S.P./gallon) $18 $14.08=1.1*(8.8+1+3) $16.75

Revenue $1800 $1408 $1675

(T.I.C.) $1300 $880 $100

(V.C.-$1/gallon) $100 $100 $100

(F.C.) $300 $300 $300

O.P. $100 Rank 2 $128 Rank 2 $275 Rank 1

3.Refining Divison(S.P./gallon)* $52 $52 $52

Revenue(price*50) $2600 $2600 $2600

(T.I.C.) $1800 $1408 $1675

(V.C.-$4/gallon) $400 $400 $400

(F.C.) $300 $300 $300

O.P. $100 Rank 2 $492 Rank 1 $225 Rank 2

Cost Based Methods

(i) Cost Price

 goods or services are transferred at their actual cost of

production.

 useful for those units where the responsibility of profit

performance is centralized.

 the selling division does not earn any profit and the purchasing
department's profit is inflated.
Cost Based Methods

(ii) Standard Cost

 Under this method, all transfers are valued at
standard cost.
 The supplying division normally absorbs variances
from standard cost.
 Once the standards are properly set, operation of this
system is simple.
 Profit performance of each division cannot be
measured and therefore, the responsibility of profit
performance is centralized.
Cost Based Methods

(iii)Cost Plus a Normal Mark-up

 Under this method, the transfer price includes, besides unit cost
of production, some profit margin or normal mark-up.
 The price received/ paid by the selling and purchasing
department respectively includes an element of profit.
 The mark-up can be determined in two ways. It is either a target
profit fixed by the management or a profit margin equal to that,
which competing organizations may reasonably be expected to
realize. When the second basis is adopted, the transfer price
approximates the market price.
Cost Based Methods

(iv) Incremental Cost

 When the entire production of the selling division is transferred

internally and there are no outside customers, incremental cost
includes all variable cost plus any fixed costs directly
attributable to internal transfer. Such a transfer price is not
appropriate for measurement of divisional performance.
 When there are outside customers for the goods and the
division is not able to produce the full demand (from the outside
customers as well as sister divisions), the incremental cost to
the selling division would be the revenue lost on sales to outside
customers i.e. the market price. Such a cost is useful for profit
centre analysis.
Market Price Based Methods
The market price can be arrived at in three ways:
(i) Through prevailing market price if there is an active market for
goods and services transferred between divisions. The prevailing
price is adjusted for discounts and selling costs, which are not
involved in inter- divisional exchange. This method has the
following merits:
(a) market prices represent alternatives to the division. That is market
price will be the basis, if the selling division sells the goods to the
outside customers and the buying division purchases from outside
suppliers.
(b) market prices are neither arbitrary nor artificial. Such a transfer price
gives the following advantages to the selling division:
- no risk of bad debt
- no direct promotional expenses.
(c) The buying department will have the advantages of assured delivery
schedule and full customer service.
Market Price Based Methods

(ii) Where easily identified market prices are not available,costs

plus a normal profit provides a reasonable approximation of the
market price.

(iii) Where the market price is not available, bids are invited from
different manufacturers and the lowest bid is taken as the
market price and used for internal transfer pricing. The
limitation of this method is that the bidders may either tender
spurious bids or may not bid at all, knowing that the firm does
not intend to buy goods but intends to use the bid for internal
purposes.
Negotiated Prices Method
 The inter-divisional transfer price can also be based
on a price mutually agreed upon by the buying and
selling divisions through negotiations.
 The advantage of this method is that it will lead to a
transfer price, which is mutually advantageous to
both the divisions and the organization as a whole.
 This method, however, can be applied only in those
situations in which the selling division has the choice
of customers and the purchasing division has choice
of suppliers.
Special Pricing:Dual (Two-way) Prices

 Under this method of transfer pricing, the transferring division is

credited with one price and the acquiring division is charged at a
different price.

 This method eliminates the possibility of conflict caused by a

single transfer price in which case one segment receives
relatively less contribution of profit because the price setting
process entitles the other segment to receive relatively more.
 Comparison of Different Transfer Pricing Methods

Criteria Market Price Based Cost Based Methods Negotiated Price

Methods Method
Achieve goal Yes, when the Often, but not Yes
congruence markets are always
competitive
Useful for evaluating Yes, when the Difficult, unless Yes, but transfer
unit performance markets are transfer price prices are affected
competitive exceeds full cost by bargaining
strength of divisions
Motivate Yes Yes, when based on Yes
management effort budgeted costs. Less
incentive to control
costs if transfers are
based on actual costs
Preserves sub-unit Yes, when the No, because it is rule Yes
autonomy markets are based
competitive
Other factors No market may exist Useful for Bargaining and
or markets may be determining full cost negotiation take
imperfect or in of products and time. Price may need
distress services, easy to to be revised
implement repeatedly as
conditions change.
 Conclusion:

 There is no method, which meets all the criteria. The transfer price a
company will eventually depends on the economic circumstances and
the decision at hand.

 The following general guideline (formula) is a helpful first step in setting
a minimum transfer price in many situations:
 Minimum Transfer Price = Additional outlay cost per unit
incurred because goods are transferred +Opportunity cost per
unit to the organization because of the transfer

 Additional outlay cost- means the additional cost of producing and

transferring the products or services.
 Opportunity cost -maximum contribution margin foregone by the selling
sub-unit, if the products or services are transferred internally.