Module IV

Transfer Pricing

Objectives

To understand the concept of Transfer Pricing.

To analyze the Transfer Pricing methods.
To understand the problems of corporate services pricing.
How is the administration of Transfer Pricing in the
organization?

Transfer Pricing and its objectives

If two or more profit centers are jointly responsible for product
development, manufacturing and marketing, each should share in the
revenue generated when the product is finally sold.
The transfer price is the mechanism for distributing this revenue.
The transfer prices should be designed to accomplish different
objectives like;
- It should provide each business unit with the relevant information it
needs to determine the optimum trade-off between company costs and
revenue.
- It should induce goal congruent decisions means the decisions which
can improve business unit profit will also improve company profits.
- It should help measure the economic performance of the individual
business units.
- The system should be simple to understand and easy to administer.

Transfer Pricing Principles and Mechanism

The transfer pricing issue is actually about pricing in general, modified

slightly to take into account factors that are unique to internal
transactions.
The fundamental principle is that the transfer price should be similar to
the price that would be charged if the product were sold to outside
customers or purchased from outside vendors.
The ideal situation to implement the Transfer Pricing in the
organization should have following components:
- Competent People
- Good Atmosphere
- A Market Price
- Freedom to source
- Full Information
- Negotiation

Contd.
Constraints on Sourcing: because of the corporate policies
or other constraints it is not feasible to source for the
purchase and sales department.
- Limited Markets
- Excess or shortage of industry capacity

Types of Transfer Pricing

1. The Profit Markup: In calculating the profit markup
-

2.

there are two decisions: a) what the profit markup is

based on and b) the level of profit allowed.
the simple and most widely used base is percentage of
costs.
The amount of profit earned should not be high than the
rate of return the independent business unit can earn if it
sells the product outside.
Agreement among business units: some companies
establish a formal mechanism whereby representatives
form selling and buying department meet periodically to
decide on outside selling prices and the sharing of
profits.

Contd.
3. Two step pricing: first, for each unit sold, a charge is made that is
equal to the standard variable cost of production. And second, a
periodic charge is made that is equal to the fixed costs associated with
the facilities reserved for the buying unit.

4. Profit Sharing: if the two step pricing system is not feasible, a

profit sharing system can be used to ensure the congruence between a
business unit and a company.
This system can operate as follows:
- the product is transferred to the marketing unit at standard variable
cost.
- After the product is sold, the business units share the contribution
earned, which is the selling price minus the variable manufacturing
and marketing costs.

Administration of Transfer Prices

i)
-

After formulating the transfer pricing, the proper implementation is

necessary. Specifically,
the degree of negotiation allowed in setting transfer pricing
methods of resolving transfer pricing conflicts
And classification of products according to the appropriate method.
Negotiation
in most companies, the transfer prices are decided by the buying and
selling department together and top management is not indulging into
that as the profit responsibility are given to both the departments.
The units negotiate with each other for the prices and earning the
profit. Business units must be aware about the ground rules of the
transfer prices which they need to follow.
They can decide on their own about either source or to purchase/sale
internally.

Contd.
ii) Arbitration and conflict resolution:
- no matter how specific the prices are there may be
situations where business units will not be able to agree on
a price.
- Thus, the arbitration is required and in company the
financial vice president or executive vice president is
taking this responsibility. They can talk to business unit
and announce the prices.
- The another method is to form a committee which will be
taking the responsibilities like settling transfer pricing
disputes, reviewing sources changes and changing the
transfer prices rules when appropriate.

Contd.
iii) Product classification:
- the extent and formality of the sourcing and transfer
pricing rules depend to a large extent on the number of
inter-company transfers and the availability of markets and
market prices.
- The organization can divide the products into different
categories as per the sourcing decisions. If organization
does not want the department to source outside for the
secrecy level they can put control over it and vice a versa.