Transfer pricing

• In multidivisional decentralized units, for measuring efficiency

of a center regarding interdivisional transfer, transfer pricing
method is used.

• It is defined as value of transfer of services or goods between

two or more profit centers as negotiated by the divisions among
themselves in order to calculate each division profit / loss.

• To determine TP / objectives of TP-

– fairness & goal congruence is necessary i.e. pursuing
decentralization (same price as if charged to outside
customer) & at same time not forgoing benefit of
centralization (interest of center should not supersede overall
goals i.e. the price negotiated must be same as if the top
management determines it)
 Transfer pricing
• Prerequisites for goal congruency
– Competent people- negotiation, long term / short
term goals
– Good atmosphere - trust
– Details of market prices- similar product
– Freedom to source- to buy / sell in open market
– Availability of information-alternatives / market
– Scope for negotiation
 Transfer pricing
• Situation not favourable for goal congruency
– Limited markets
• Ex company is sole producer
– Excess / shortage of industrial capacity
• When excess industrial capacity buying center will purchase from
outside market
• When shortage in industry selling center will sell to outside market
– Sourcing constraints
• When there is excess or shortage of industrial capacity,the
arbitration committee would then make sourcing decision in
companies best interest
 Methods of calculating TP
• Market based pricing-
– price similar to that prevailing for those goods/services in
open market
– Business units operates as independent profit centers
– Autonomy increases motivation
– Taxation authorities accepts is it is transparent
– Its not in practice
• there is no market or market is not competitive or
distorted by monopoly
• Definite market price is difficult to determine as there
is variance in prices due to change in taxes &
transportation cost
• Prices are fluctuated with demand & supply
• Cost based pricing
– Calculates prices on basis of cost available with cost records
– It is well accepted by taxation authority as it provides
indication of real cost
– But this cost can be manipulated by the company so many
times these are not transparent
– Secondly managers argue that arbitrators are responsible for
the low profit of the center

• Negotiated pricing
– Buyers & sellers negotiate freely
– As each unit is accountable,it encourages cost minimization
– Tax authorities discourages it as company minimize tax
 Upstream fixed cost & profit
• In integrated companies like Oil,paper companies where raw
material is further processed for production of final
product,the selling division is not aware of the fixed costs
involved in internal purchase price & it might sell final
product at a price which may not recover fixed cost.

• To avoid this three methods:-

– A) Two step pricing
• Product is charged with the variable price
• Then at second stage it is charged with fixed cost
• Total of two is the transfer price of the product
 Practical problem
• Expected monthly sales from X to Y 5000 units
• Variable cost 5/-
• Monthly fixed cost 20000/-
• Investment in working capital 1200000
• ROI 10 %

METHOD 1
VARIABLE COST PU 5
FIXED COST PU 4
PROFIT PU 2
TP PU 11

Total cost charged 5000 * 11 = 55000/-

 PRACTICAL PROB CONTD.

IF THE TRANSFER FOR 2ND MONTH IS 4OOO UNITS

METHOD 1

TP 4000*11= 44000

TWO STEPS METHOD

TP 4000*5 = 20000+30000=50000 i.e. 12.5/- PU
• This represents the penalty for not using the portion of unit X that it has reserved
• Conversely unit Y will pay less when it sales more than 5000 units a month
TP 6000*5 = 30000 +30000 =60000 i.e. 10 /-PU
 Upstream fixed cost & profit

B) Profit sharing

– Product is transferred to sales unit at variable cost & then

profit is shared between two units which is sales price
minus the variable cost & marketing cost per units

– There is disagreement between two units for sharing profit

& arbitrator committee intervenes.

– This method is good when demand is not steady to warrant

permanent assignment facilities as in the two step method
 Upstream fixed cost & profit
• C) Two sets of prices
• Revenue is credited to manufacturing unit at sales price &
the buying unit is charged to total standard cost.
• The difference between outside sales price & standard cost
is charged to parent company’s account
• These charges are later eliminated while drawing
consolidation of accounts.
• It used when there are frequent conflicts between units
• Here the additional book keeping is to be maintained &
managers are concerned with internal prices transfer only
• Sum of unit profit is more than company’s profit so
controller should be careful for budget allocation
 Administration of transfer prices
• Negotiation
– to use capacity of the unit of same company & maximizing
overall profit of the parent company
• Arbitration-
– By parent company by appointing a committee or a single
executive
– In formal control both units give written submission to
arbitrator while in informal oral representations are given
• Product classification
– The larger the intra company transfer &less the availability
of market price more is the formal transfer pricing rules
– Some company divides products into two types
• Those product whose TP is to be controlled by top
Management
• Those which can be produced outside company ( TP
market price)