TRANSFER PRICING

Transfer Pricing
A transfer price is the price one subunit
charges for a product or service supplied
to another subunit of the same
organization
Intermediate products are the products transferred between
subunits of an organization.

Whats the Problem?

Determination of Appropriate transfer price
For selling division it is a source of
REVENUE BUT for the buying division it
is an element of COST

Selling division

Buying Division

Transfer pricing should help achieve

a companys strategies and goals.
transfer price should be objectively determinable.
It should be equal to the value
of intermediate products being
transferred
compatible with company goals

Market-based transfer prices

Cost-based transfer prices
Negotiated transfer prices

Cost Based
According to this approach, Transfer price
is equal to Cost price
Cost could be Actual cost of Production or
standard cost of Production.
Merits
Simple and convenient
Demerits
Inappropriate for Profit Centre Analysis

Cost Plus a Normal Mark- up

It includes cost of production plus a normal Mark
up
Mgmt of the firm may set a target profit
OR
Equivalent to the profit margin that the
competing firm might be expected to realize
If second basis is adopted, transfer price will
approximate the MARKET VALUE
In first basis, the mark up is an artificial margin
No Unique value of its own for Profit Centre
Analysis

Incremental Cost
Situation 1- entire production of the selling
division is transferred to the sister
division, no independent outside customer
for the goods.
Incremental cost - variable cost plus fixed
cost attributable to the internal transfer
Drawbacks- inconsistent with the objective
of measuring divisional profit

Situation 2- There may be outside customer and

the division is unable to produce to meet the
demand from outside customer as well as sister
division
Incremental costs- revenue lost on sales to outside
customer that must be foregone to make an
internal transfer.
i.e. incremental cost = Market price of those goods
Merits- Useful for profit centre analysis

Market price
No.1:- prevailing market price if there is an
active market ,discounted to the extent of
certain selling costs not involved in the
inter divisional exchange.
Merits:-1. Reflects collective value of
buyers and sellers.
2. No risk of bad debts
3. No direct promotional expenses

No.2:- market prices are not easily available

~ Cost + normal profit margin
No.3:- In case Market Price is not readily
available, bids from several different
manufacturers can form the basis and the
LOWEST BID may be taken as a market
price
Demerits:- spurious bids may be submitted
by the bidders

Negotiated Price
Mutually agreed upon by the buying as well
as selling department
Merits:- Mutually advantageous to both the
buyer and seller
Demerits:- can be applied when selling and
buying division has a choice outside the
organisation

Confused? Which one to choose?

Management performance Assessment
Market price
If Market price not available, go for negotiations
If there is no competitive market price and negotiated
price can not be established,
FIRM CANNOT SET UP PROFIT CENTER
Then use cost center as management performance
measurement and encourage the selling division to have
good cost control