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Q3.

) What is the ideal transfer pricing in the situation of a) Limited Market b) Shortage of Capacity in Industry c) When do you use Cost based transfer pricing Ans.- a) Limited market:- The ideal transfer price is based on a well-established, normal market price for the identical product being transferred is a market price reflecting the same conditions (quantity, delivery time, and quality) as the product to which the transfer price applies. The market price may be adjusted downward to reflect savings accruing to the selling unit from dealing inside the company. For eg. there would be no bad debt e x p e n s e , a n d a d v e r t i s i n g a n d selling costs would be smaller when products are transferred from one business unit to another within the company. Although less than ideal, a market price for a similar, but not identical, product is better than no market price at all. By limited market it means that the markets for buying and selling profit centers may be limited. Even in case of limited market the transfer price that is ideal or satisfies the requirement of a profit center system is the competitive price. In case if a company is not buying or selling its product in an outside market there are some ways to find the competitive price.They are as follows: 1. If published market prices are available, they can be used to establish transfer prices. However, these should be prices actually paid in the market-place and the conditions that exist in the outside market should be consistent with those existing within the company. For example, market prices that are applicable to relatively small purchases are not valid in this case

2. Market prices are set by bids. This generally can be done only if the low bidder has a reasonable chance of obtaining the business. One company accomplishes this by buying about one-half of a particular group of products outside the company and one-half inside the company. The company then puts all of the products out to bid, but selects one-half to stay inside. The company obtains valid bids, because low bidders can expect to get some of the business. By contrast, if a company requests bids solely to obtain a competitive price and does not award the contracts to the low bidder, it will soon find that either no one bids or that the bids are of questionable value. 3. If the production profit center sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price. 4. If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products. This can be done by calculating the cost of the difference in design and other conditions of sale between the competitive products and the proprietary products. So we see from the above arguments that market price is ideal transfer price even in limited market. b) Shortage of Capacity in Industry :- The buying profit center cannot obtain the products it requires from the outside while the selling profit center is selling to the outside. This situation occurs when there is a shortage of capacity in the industry. In this case, the output of the buying profit center is constrained and again company profits may not be optimum If the no. of intracompany transfers is small or if the situation is temporary, many companies let buyers and sellers work out their own relationships without central intervention. Even if the no of intracompany transfers is significant, some senior managements still do not intervene on the theory that the benefits of keeping the profit

centers independent offset the loss from sub-optimising company profits. Therefore, even in the situation of shortage of capacity in Industry when there are constraints in on sourcing, The market price is the best transfer pricing price. If the market price exists or can be approximated, use it. However,if there is no way of approximating valid competitive prices, the other option is to develop cost based transfer prices. c.)When do you use Cost based transfer pricing :- If competitive prices are not available,Transfer prices may be set on the basis of cost plus a profit,even though such transfer prices may be complex to calculate and the results less satisfactory than a market-based price.Two decisions must be made in a cost-based transfer price system: (i) How to define cost and (ii) How to calculate the profit markup. The Cost Basis:- The usual basis is standard costs. Actual costs should not be used because production inefficiencies will be passed on to the buying profit center. If standard costs are used, an incentive is needed to set tight standards and improve standards. The Profit Markup:- In calculating the profit mark up, There also are 2 decisions:- (i) what the profit mark up is based on and (2) the level of profit allowed. The simplest and the most widely used base is a percentage of costs. If this base is used, however no account is taken of the capital required. A conceptually better base is a percentage of investment but calculating the investment applicable to a given product may pose a major practical problem. If the historical cost of the fixed assets is used, new facilities designed to reduce prices could actually increase costs because old assets are undervalued.

The second problem with the profit allowance is the amount of profit. The conceptual solution is to base the profit allowance on the investment required to meet the volume needed by the buying profit centers. The investment would be calculated at a standard level with fixed assets and inventories at current replacement costs.

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