Transfer Pricing – Definition, Objectives and Principles

Meaning and Definition of Transfer Pricing

Large organizations are divided into a number of divisions to facilitate managerial control. The problem of transfer pricing arises when one division of the organization transfers its output to another division as an input. A transfer price is the price one segment (sub unit, department, division etc.) of an organization charges for a product or service supplied to another segment of the same organization. The transfer from one segment to another is only an internal transfer and not a sale.

Transfer pricing is needed to monitor the flow of goods and services among the divisions of a company and to facilitate divisional performance measurement. The main use of transfer pricing is to measure the notional sales of one division to another division. Thus the transfer prices used in the organization will have a significant effect on the performance evaluation of the various divisions. This requires that the system of transfer pricing should be objective and equitable. Transfer pricing becomes necessary when there are internal transfers of goods or services and it is required to appraise the separate performances of the divisions or departments involved.

Transfer pricing is the process of determining the price at which goods are transferred from one profit center to another profit center within the same company. If profit centers are to be used, transfer prices become necessary in order to determine the separate performances of both the ‘buying’ and ‘selling’ profit centers. If transfer prices are set too high, the selling center will be favored whereas if set too low the buying center will receive an unwarranted proportion of the profits.

Transfer Pricing Methods

In a simple terms the term Transfer pricing refers to the prices that related parties charge one another for goods and services passing between them. The most common application of the Transfer pricing rules is the determination of the correct price for sales between subsidiaries of a multinational corporation. These prices can be used to shift profits to tax-favored jurisdictions, If in a transaction between a subsidiary in a high-tax jurisdiction and another in a low-tax jurisdiction, the high-tax subsidiary charges a price below the “true” price, some of the group’s economic profit is shifted to the low-tax subsidiary. Obviously taxpayers would want to engage in this sort of behavior because it can significantly reduce their taxes. If there were no limitations on this behavior, the entire income of multinational corporations would be taxed at the lowest tax rate in the world to zero rate of taxation. Consequently most countries have some set of tax rules that regulate the prices that related persons can charge one another.

Since the products and services would be transferred within the company itself, the external market mechanism to set transfer prices may not necessary apply. The method by which transfer prices are set is determined by management and can be any of the following five broad systems:

  1. Market-based transfer prices – when an external market exists for the item being transferred between the company’s divisions, the transfer price is set equal to the market price.
  2. Marginal cost transfer prices – the goods or services are transferred at the marginal cost of producing the item. Many a times, marginal cost is approximated by the short-run variable cost.
  3. Full cost transfer prices – the selling division transfers the asset at a price equal to the full production cost of the product or service. To achieve full cost, many companies usually add a mark-up percentage to the variable cost of the good or product to ensure covering fixed costs committed to production.
  4. Cost-plus a mark-up transfer prices – the products or services are transferred at a price equal to cost plus a profit mark-up so that the supplying division will be able to show a profit on such transfers.
  5. Negotiated transfer prices – managers of the supplying and receiving department will negotiate the inter-divisional transfer price between them, having regard of the market price and costs of the product or service.

Objectives of Transfer Pricing

1. Goal congruenceThe prices should be set so that the divisional management desire to maximize divisional earnings is consistent with the objectives of the company as a whole. The transfer prices should not encourage sub-optimal decision-making. The system should be so designed that decisions that improve business unit profits will also improve company profits.

2. Performance appraisal: The prices should enable reliable assessments to be made of divisional performance. The prices form part of information, which should:

  1. Guide decision making
  2. Appraise managerial performance
  3. Evaluate the contribution made by the division to overall company profits.
  4. Assess the worth of the division as an economic unit.

The transfer prices should be designed such that they help in measuring the economic performance

3. Divisional autonomy:  The prices should seek to maintain the maximum divisional autonomy so that the benefits of decentralization (motivation, better decision-making, initiatives, etc.) are maintained. The profits of one division should not be dependent on the actions of other divisions.

4. Simple and easy: The system should be simple to understand and easy to administer.

5. The transfer price should provide each segment with the relevant information required to determine the optimum trade-off between company costs and revenues.

Fundamental Principles for Transfer Price

The fundamental principle is that he transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchase from outside vendors. When profit centers of accompany by from and sell to one another, two decisions must be made periodically for each product that is being produced by one business unit and sold to another:

  1. Should the company produce the product inside the company or purchase it form and outside vendor? This is the sourcing decision.
  2. If produced inside, at what price should the product be transferred between profit centers? This is the transfer price decision.

Transfer price systems can range from the very simple to the extremely complex, depending on the nature of the business.