Transfer Pricing

• Transfer Price,
▫ is a price assigned to products (goods/services) that
are transferred among the profits centres.
• The Objectives:
▫ It should provide each business unit with the relevant
information it needs to determine the optimum trade-off
between company costs and revenues.
▫ It should induce goal congruent decisions-that is, the
system should be designed so that decisions that improve
business unit profits 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.
 Fundamental Principle
• 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.
• Decisions associated to transfer price:
1. Sourcing decision,
 Should the company produce the product
inside the company or purchase it from an
outside vendors.
2. Transfer price decision,
 If produced inside, at what price should the
product be transferred between profit centres.
 The Ideal Situation
• Market price-based transfer price
V.S.
• Cost-based transfer price
The requirement of market-based transfer price:
1. Competent people
2. Good atmosphere
3. A market price
4. Freedom to source
5. Full information
6. Negotiation
 Constraints on Market-based
1. Limited markets
▫ the existence of internal capacity might limit the
development of external sales.
▫ if a company is the sole (one and only) producer of a
differentiated product, no outside source exists.
▫ if a company has invested significantly in facilities, it is
unlikely to use outside sources
Solution to limited market:
 published market price
 bids
 use similar products as the guideline for transfer
price
2. Excess or Shortage of Industry Capacity
 Cost-Based Transfer Price
• is transfer price that based on “cost plus”
pricing.
Decisions involved:
1. how to define costs
2. how to calculate the profit mark-up (plus)
• Cost Define
▫ Standard cost versus actual cost?
• The Profit Mark-up
▫ what the profit mark-up is based on?
▫ what the level of profit allowed?
 Upstream Fixed Costs and Profits
• Solutions:
1.Agreement among Business Units
2.Two-Step Pricing
▫ First, for each unit sold, a charge is made that is
equal to the standard variable cost of production.
▫ second, a periodic (usually monthly) charge is made
that is equal to the fixed costs associated with the
facilities reserved for the buying unit.
3.Profit Sharing
4.Two Sets of Prices
▫ the manufacturing unit’s revenue is credited at
outside sales price and the buying unit is charged
the total standard costs.
 Two-Step Pricing

• Business Unit “X” transfers product to Business Unit “Y”

▫ Expected monthly sales to “Y” 5,000 units
▫ Variable costs per unit $5
▫ Monthly fixed costs assigned to product $ 20,000
▫ Investment in working capital & facilities $
1,200,000
▫ Competitive return on investment per year
10%
At what price the product transferred to “Y”?
▫ Step One, assigned variable costs
▫ Step Two, assigned fixed costs and profits
 Administration of Transfer Prices
1. Negotiation
2. Arbitration and Conflict Resolution
▫ Arbitration committee is responsible for:
 settling transfer price disputes
 reviewing sourcing changes
 changing the transfer price rules when
appropriate.