TRANSFER PRICING

TRANSFER PRICING (TP)

TP is the internal selling price used when goods and services
are transferred between profit centres and investment centres in
a decentralised organisation
TP is the revenue for the selling unit and cost for the buying unit

TP allows the selling unit to earn profit to reflect their effort in
producing the product
The transfer price should
Result in unit profits that are a reliable and an accurate measure of unit
performance
Preserve and encourage autonomy within units
Encourage goal-congruent behaviour
 TRANSFER PRICING
WHO SETS THE TRANSFER PRICES?
Managers of profit centres and investment centres may have
considerable autonomy in deciding whether
to accept or reject orders for goods or services
to source their materials inside or outside the organisation
to set and accept transfer prices

Direct intervention by corporate (head office) managers to

dictate specific transfer prices may be inconsistent with the
philosophy of decentralisation
Corporate management may develop general policies to
govern transfer pricing practices
 TRANSFER PRICING
TRANSFER PRICING METHODS
Market-based prices
Cost-plus prices
Negotiated prices

(1) MARKET-BASED PRICES

Need competitive external markets for a product
Advantages:
Stimulates the competitive characteristics of the free market and
ensure both transferor and transferee behave as if at arm’s length
Should be seen to be fair by transferor and transferee
 TRANSFER PRICING
(2) COST-PLUS PRICES
Where there is no external market price

Intermediate products have no market outside the company

and are processed further to become final products
Standard variable cost plus mark-up allows supplying unit to
show a contribution margin on the transferred product
Standard absorption cost may lead to overpricing of
products and dysfunctional decisions
Standard costs should always be used in favour of actual
costs, to prevent cost inefficiencies being passed on to
buying unit
 TRANSFER PRICING
(3) NEGOTIATED PRICES

The managers of profit centres and investment centres may

negotiate the price at which transfers will be made

Market price may form the starting point, and cost may be
the lower boundary

An important issue in setting the transfer price is whether or

not the supplying unit has spare capacity
 GENERAL TRANSFER PRICING RULE
Provides guidance on the appropriate transfer price
Represents a minimum transfer price
May guide unit managers to make goal-congruent decisions
EXAMPLE:
Mekar Bhd. operates two autonomous divisions: X and Z. Division X produces Component
Tee with a ready competitive market. Division Z can use this component for its product.
Currently, Division Z is selling 500 units of its product at RM2,400 per unit. The market price
for the component is RM1,400 per unit. The variable cost of Division X is RM1,040 per unit,
while the variable cost of Division Z, other than component costs, is RM1,200 per unit.

The manager of Division Z feels that Division X should transfer Component Tee to his
division at a price lower than the market because at the market price, Division Z is unable to
make profit. Division X is willing to sell to Division Z at a 20 percent reduction in price. The
capacity for Division X is 1,000 units, and is only able to sell 500 units in the open market.

Required:
a)Based on the transfer pricing rule, what should be the transfer price?
b)Prepare a schedule showing comparisons of contribution margins for each division and
the group as a whole under three different alternatives:
(i)transfer price as in (a),
(ii)transfer price at 20 percent reduction from market price
(iii)no transfer.
c) Discuss the effect on transfer price if Division X is able to sell all 1, 000 units in the
open market.
 BUYING UNITS 500 units
@ RM2,400 / unit EXTERNAL
Processing cost = RM1,200 DIVISION Z CUSTOMER

500 units
Capacity = 1,000 units @ RM1,400 / unit EXTERNAL
Variable cost = RM1,040 DIVISION X CUSTOMER

SUPPLYING UNITS

SUGGESTED SOLUTION:

a) Based on the transfer pricing rule, what should be the transfer price?

Transfer Additional outlay cost per unit Opportunity cost per unit to the
= + supplying unit
Price incurred by supplying unit

Transfer price = RM1,040 + 0

= RM1,040
(b)(i) - Alternative 1: Transfer at RM1,040

DIVISION X DIVISION Z MEKAR BHD

Internal sales (500 x 1,040) 520,000 -
External sales (500 x 1,400) 700,000
(500 x 2,400) 1,200,000 1,900,000
Variable costs (1,000 x 1,040) 1,040,000
(500 x 1,200) 600,000 1,640,000
Transfer price (500 x 1,040) 520,000 -
CONTRIBUTION MARGIN 180,000 80,000 260,000

(b)(ii) - Alternative 2: Transfer at RM1,120 (80% x 1,400)

DIVISION X DIVISION Z MEKAR BHD

Internal sales (500 x 1,120) 560,000 -
External sales (500 x 1,400) 700,000
(500 x 2,400) 1,200,000 1,900,000
Variable costs (1,000 x 1,040) 1,040,000
(500 x 1,200) 600,000 1,640,000
Transfer price (500 x 1,120) 560,000 -
CONTRIBUTION MARGIN 220,000 40,000 260,000
EFFECT (INCREASE / DECREASE) INCREASE DECREASE REMAIN
 (b)(iii) - Alternative 3: No transfer – acquire from external at RM1,400

DIVISION X DIVISION Z MEKAR BHD

External sales (500 x 1,400) 700,000
(500 x 2,400) 1,200,000 1,900,000
Variable costs (500 x 1,040) 520,000
(500 x 1,200) 600,000 1,120,000
Purchase cost (500 x 1,400) 700,000 700,000
CONTRIBUTION MARGIN 180,000 (100,000) 80,000
EFFECT DECREASE DECREASE DECREASE

CONCLUSION
Division X  prefer a TP at RM1,120 since the contribution is higher. If transfer at RM1,040, the
profit will be the same as if there is no transfer.

Division Z  prefer a TP at RM1,040 since the contribution is higher.

Based on goal congruence  Division Z should accept TP at RM1,120 since Division X will not
transfer at the price less than this price.
c) If sell 1,000 units to open market  has to forego the opportunity to transfer to Division Z – involves
opportunity cost of RM360 per unit ( RM1,400 – RM1,040).
 TP : THE INFLUENCE OF INCOME TAXATION
Transfer pricing is used by many companies to effectively
‘transfer profits’ between business units in different countries

International transfer prices may be influenced by the different

taxation rates and different regulations across countries

International tax considerations may influence the transfer

prices that are used for domestic purposes
 TP IN SERVICE FIRMS
Service firms and not-for-profit organisations may use transfer
pricing when services are transferred between business units
A service level agreement (SLA) is a contract between two
units within an organisation which
– establishes the nature of the service that will be provided by
one unit to the other
– outlines the responsibilities of each party
– outlines price, quality and timing of service delivery,
performance targets, problem-solving arrangements, ways
in which the agreement can be changed or terminated
• Transfer price can be determined using methods similar to
those used for the transfer of goods
 END OF
TRANSFER PRICING