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 broad systems. The methods of transfer pricing can be divided into four categories:

Market based transfer pricing
Cost based transfer pricing
Negotiated transfer pricing
Opportunity cost transfer pricing

1. Market Based Transfer Pricing

Where a market exists outside the firm for the intermediate product and where the market is competitive (i.e. the firm is a price taker) then the use of market price as the transfer price between divisions would generally lead to optimal decision making. Such a price would meet all of the objectives of a transfer price i.e.

Where significant external buying and selling costs exist then a transfer may be set somewhat lower than market price to reflect the cost savings from internal transfers. The circumstances may lead to negotiated market prices where the total cost savings are apportioned between the buying and selling divisions. In such circumstances an arbitration procedure may be required but too much central intervention of this nature could undermine the autonomy of the divisions.

Where appropriate market price exists then their use represents a feasible ideal. However the following difficulties may arise in applying the concept:

No market for the intermediate product or service being considered
Though market exists, difficulty in obtaining a competitive price. (price is only strictly comparable when all features are identical- quality, delivery, finish, and so on.
Market exists but is not perfectly competitive i.e . the market is affected by the pricing decision of divisional managers.
Market prices that are available may be considered unrepresentative eg. there may be considerable excess capacity in the intermediate market that current quotations are well below long run average price. In such circumstances the use of either the current, abnormally low price or the long run “normal” price may lead to sub-optimal decision making on the part of the supplying divisional management or to loss of motivation and autonomy of the purchasing division.

Adjusted market price: Inter-divisional transfers in most situations cannot replicate a competitive market situation. A division may have the advantage or disadvantage of being a captive buyer or captive supplier. Capacities may be related which are different from the economically competitive capacities to take advantage of the synergies of integration or to remove the uncertainties attached with the supply of critical items by outside parties, etc. these and many other factors may be considered while fixing the transfer prices. They will thus justify the setting of transfer prices based on adjusted market price. The extent of adjustment to market price will still have to be decided.

2. Cost Based Transfer Pricing

Cost based transfer pricing systems are commonly used because the conditions for setting ideal market prices frequently do not exist; eg. there may be no intermediate market or the market which does exist may be imperfect.

Providing that the required information is available, a decision rule that would lead to optimal decisions for the firm as a whole, would be to transfer at marginal cost up to the point of transfer, plus any opportunity cost to the firm as a whole.

Limitations:

Even assuming that variable outlay costs as conventionally recorded in accounting systems, are a reasonable approximation of economic marginal costs the imposition of such a rule would undermine the concept of profit centers in that the profitability of divisions required to transfer at marginal cost could not be appraised and

The autonomy of divisions would be affected.
The cost may include inefficiencies of the selling division which would thus be passed on to the buying division. Accordingly, standard cost, rather than actual costs should be used as the basis of the transfer price in order not to burden the buying department with the inefficiencies of the supplying department.

The two main cost derived methods are those based on full cost and variable cost.

1. Full Cost Transfer Pricing

In this method, the transfers are made at full costs plus a profit markup. The full cost (or cost plus) is likely to be treated by the buying division as an input variable cost so that external selling price decisions , if based on cost may not be set at levels which are optimal as far as the firm as a whole is concerned.

Limitations of full cost transfer pricing;

The calculated cost is only accurate at one level of output.
The validity of any pricing decision base on past costs is questionable
When transfers are made at full cost plus a profit markup the selling division is automatically given a certain level of profit rendering genuine performance appraisal difficult
When the selling division is inefficient or working at low volume the costs may be unacceptably high as far as the buying division is concerned.

2. Variable Cost Transfer Pricing

Here transfers are made at the (standard) variable costs up to the point of transfer. Assuming that the variable cost is a good approximation of economic marginal cost then this system would enable decisions to be made which would be in the interest of the firm as a whole.

However, variable cost based prices will result in a loss for the selling division so performance appraisal becomes meaning less and motivation will be reduced.

Sub-optimal decision making may be minimized by the following:

a. Two step pricing: a transfer price is established that includes two charges:

A charge is made for each unit sold that is equal to the standard variable cost of production.
A periodic (usually monthly) charge is made that is equal to the fixed costs associated with the facilities reserved for the buying unit.

One or both of these components should include a profit margin.

b. Profit sharing: a profit sharing system might be used to ensure congruence of business unit interest with company interest. This operates as follows:

The product is transferred to the marketing unit at standard variable cost.
After the product is sold, the business units share the contribution earned, which is the selling price minus the variable manufacturing and marketing costs.

This method of pricing may be appropriate if the demand for the manufactured product is not steady enough to warrant the permanent assignment of facilities, as in the 2-step method. In general, this method accomplishes the purpose of making the marketing unit’s interest congruent with the company’s. This dual transfer price approach has an apparent fairness in that credit for profits earned and shared between divisions but performance appraisal based on arbitrarily apportioned profit shares has obvious shortcomings and administrative difficulties.

The problems in implementing a profit sharing system are:

There can be arguments over the way contribution is divided between the two profit centers. Senior management might have to intervene to settle these disputes which is costly, time consuming, and works against a basic reason for decentralization, namely, autonomy of business unit managers
Arbitrarily dividing up the profits between units does not give valid information on the profitability of each segment of the organization.

Since the contribution is not allocated until after the sale has been made, the manufacturing unit’s contribution depends on the marketing unit’s ability to sell and on the actual selling price. Manufacturing units may perceive this situation to be unfair.

A variable cost based transfer price so that and, as a separate exercise, credit the supply division with a share of the overall profit which eventually results from the transferred item.

3. Negotiated Transfer Pricing

Transfer price could be set by negotiation between the buying and selling divisions. This would be appropriate if it can be assumed that such negotiations would result in decisions which were in the interest of the firm as a whole and which were acceptable to the parties concerned.

A company could establish a formal mechanism whereby representatives from the buying and selling units meet periodically to decide on outside selling prices and on the sharing of profits for products having significant amounts of upstream fixed costs and profit. This mechanism is workable only if the review process is limited to decisions that involve a significant amount of business to at least one of the profit centers; otherwise, the value of these negotiations may not be worth the effort.

Limitations of negotiated transfer pricing;

Its unlikely that the parties concerned have equal bargaining power
Protracted negotiations may be time consuming and divert management energies away from their primary tasks
Disagreements which are all too likely, will require some form of arbitration by central management which itself undermines the autonomy of divisions and may cause resentment. It must be remembered that the objectives of divisionalisation is to enhance the overall efficiency of the organization so that care must be taken not to nullify any benefits through inter-divisional wrangling over transfer prices.

4. Opportunity Cost Transfer Pricing

In several cases there are situations where the pricing of inter-divisional transfers based on market price or its variants becomes difficult because of the lack of existence of reasonable market for such intermediates. This may also be the case where the supplier division is a monopoly producer or the user division is a monopoly consumer.

In such circumstances the transfer price is set by the central management an ideal option for the central management will be to set the price at a level which equals the opportunity cost of the supplier division and the user division. Both divisions under these circumstances will be encouraged to produce and consume that quantity which is optimal from the point of view of the company as a whole. If the user division fails to provide adequate orders from the supply division the amount of contribution in respect of the production foregone due to lack of orders should be charged from such division.

Transfer Pricing Methods