PRICING POLICY AND DECISIONS

Introduction:

Pricing is one of the most important decisions made by the management. It is an important
management tool to achieve the objectives of the organization. However, pricing decisions do
not rely on any one discipline but follow a highly complex process encompassing many different
theoretical aspects such as accounting, economics, and marketing. It is simultaneously affected
by cost and demand conditions which are not parallel and are difficult to align as an efficient
decision supporting the strategic objectives of the firm. If the price of a product is too low, it
leads to a high quantity of (demand and) sales but, at the same time, to low markup and profit
(profitability). If the price is too high, it gives a high markup on variable cost but may lead to
losses due to fixed costs and low demand quantity when sales volume does not exceed the
breakeven point. In order to reach a reasonable size (and growth) and profitability, the price must
be within a certain range. This price range determines in practice the degrees of freedom existing
in pricing decision making. In this range, the price should be set to best support the strategy of
the firm.

Methods of Pricing:

 Transfer Pricing
 Cost Plus Pricing
 Variable Cost Pricing
 Differential Cost Pricing
 Full Cost Pricing
 ABC and Pricing
 Rate of Return Pricing
Transfer Pricing:

Transfer pricing is the price determined for the transactions between two or more related entities
within a multi-company organization. This price is also known as the cost of transfer which
shows the value of such transfer between the related entities in terms of goods or even transfer of
employees or labor across different departments. It can lead to tax savings for corporations,
though tax authorities may contest their claims.

Objectives of Transfer Pricing:

 True and fair reporting of financial statements

 Better estimation of profits generated by entities from associated transfers
 Avoidance double taxation and avoiding tax evasion by entities
 Promoting competitiveness among the associated enterprises.
How Does Transfer Pricing Work:

The transfer price is more related to the market price of the product or service involved in such
related party transactions. This will eliminate the entities purchasing or selling such products or
services in the market as they can buy or sell them between the related parties at the market price
itself; this is the reason it is more of a accounting concept that accounts for the transaction
between such related entities at a correct and fair price.

This is determined based on a few widely accepted methods such as comparable uncontrolled
price, cost plus pricing resale price, Transactional Net margin, and transactional profit split
methods.

The above-listed methods are used based on the transaction, such as if there are comparable
products or services in the market for which there is a market price determined, then such price
could be used to determine Transfer Pricing. Similarly, if the product is resaleable and such
resale price is determined along with profit on such sale, then the resale price method can be
utilized. Related entities use other methods.

Transfer Pricing Examples:

Let us take an example of two associated entities X and Y, where X is situated in a high tax
country. On the other hand, y is located in a Low tax country which is a tax haven destination; in
this case, X would shift most of the revenue generated to Y through means of some associated
transfers to avoid taxation or reduce the incidence of tax for the company, with the use of these
provisions, such type of tax avoidance transactions could be eliminated. Similarly, due to this,
there will not be the eradication of revenue from one country to another by benefiting the country
of source of generating such revenue.
Importance of Transfer Pricing:

The critical importance of Transfer Pricing provisions is that there will be an equal and fair
distribution of resources between associated entities leading to nondiscriminatory trade
transactions.

This provides opportunities for associated enterprises to transact business between them as the
transactions are valued at market price; this will enhance the scope of business and have a
positive impact on the group company as a whole due to internal profits generated by these
associated entities,

Also, it is useful for the tax authorities to determine the actual value of such transactions and
estimate the profits derived from such transactions taking place between associate entities.
Without transfer pricing provision, there would be a reduction or avoidance of tax by misleading
authorities and transferring or reporting profits based on the limitation presented in provisions.

It is used not only by multi-company organizations but also by entities that satisfy the conditions
of associated enterprises.

Advantages of Transfer Pricing:

 Assists the entities to transact at market prices eliminating inconsistency in pricing a

transaction.
 It helps the tax authorities to determine taxes and helps reduce tax evasions.
 Fair presentation of financial statements.

Disadvantages of Transfer Pricing:

 This would require additional administrative cost and a time-consuming process.

 There are few limitations in determining arm’s-length prices as two products cannot be
compared due to the homogenous nature of such commodities or services.