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 issue of transfer pricing becomes
important when accounting is to be used for the
purpose of divisional performance measurement.
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.
 Objectives
Any transfer pricing system should aim to:
(i) Ensure that resources are allocated in an
optimal
manner.
(ii) Promote goal congruence.
(iii) Motivate divisional managers.
(iv) Facilitate the assessment of management
performance.
(v) Retain divisional autonomy.
 Requirements of Transfer Price
  (i) Transfer price should be objectively determinable.
(ii) 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.
(iii) It should be compatible with the policy that
maximizes
attainment of a company's goals and evaluation of
segment performance.
 Although different approaches will result in
different figures of transfer price, 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.
 
The difference between the two limits represents the
savings made by producing internally as opposed
to buying it from outside.
 
Methods of Fixing Transfer Prices
Transfer pricing methods are broadly classified into three
categories:
(a) Cost based prices
(b) Market based prices
(c) Negotiated prices
Cost Based Methods
(i) Cost Price
In this method, goods or services are transferred at their
actual cost of production. This method is the simplest of
all the methods used. It is useful for those units where
the responsibility of profit performance is centralized.
Under this method, it is difficult to measure the
performance of each profit centre. The selling division
does not earn any profit and the purchasing
department's profit is inflated.
(ii) Standard Cost
Under this method, all transfers are valued at
standard cost. The supplying division normally
absorbs variances from standard cost. In certain
cases variances from standard cost are transferred
to the user division and, therefore, both the
supplying and receiving divisions carry inventories
at standard cost . Once the standards are properly
set, operation of this system is simple. However, the
responsibility of profit performance is centralized.
Profit performance of each division cannot be
measured.
 (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.
Depending upon its closeness to the real market value, it
may be useful for the profit centre analysis. But in case
of a target profit, it may not be so.
 
(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. They reflect the
collective values of buyers and sellers. Such a transfer price gives
the following advantages to the selling division:
-         no risk of bad debt
-         no direct promotional expenses.
The buying department will have the advantages of assured
delivery schedule and full customer service. Therefore, where
divisions have the alternative to buy from/sell to the open
market, they would prefer to buy from or sell to the sister
division.
(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
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.
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.
The price to be charged to the acquiring division should be based
on what it costs the firm as a whole to produce and distribute the
intermediate product under normal conditions. The appropriate
cost should be the incremental cost in non-recurring situations
and full standard cost for long run continuous situations. These
prices reflect effective cost of resources consumed by the firm and
the segment. For this reason, this is an appropriate basis for
evaluating the performance of the user of the resources. At the
same time, the transferring division receives the market price for
intermediate products or a negotiated price based on the market
price of the final product.
 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.
There is no method, which meets all the criteria. The
transfer price a company will eventually choose depends
on the economic circumstances and the decision at hand.
General Guideline for Transfer Pricing
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 in this context means the
additional cost of producing and transferring the
products or services. Opportunity cost here is the
maximum contribution margin foregone by the selling
sub-unit, if the products or services are transferred
internally.
When the selling sub-unit is operating at capacity, the
opportunity cost of transferring a unit internally rather
than selling it externally is equal to the market price
minus variable cost of marketing. The opportunity cost
is zero when the selling sub-unit has an idle capacity.
When no market exists for the intermediate product,
any price between the incremental cost and the market
price can be fixed.
The units should indulge in inter-unit transfer rather than
buy outside to minimize cash outflow for the company.
One unit should not profit, if its action reduces the
utilization of capacity of another unit. For example, a
transferee unit may prefer to buy from outside though
the other unit has the capacity to supply the same. In
such a case, the overall profit of the company will be
sub-optimal.