Transfer Pricing: Basic Principles, Classification and Pricing Rule| Cost Accounting

In this article we will discuss about:- 1. Transfer Pricing- Basic Principles 2. Classification of Transfer Prices 3. General Transfer Pricing Rule 4. International Transfer Price and Tax Considerations 5. Summary.

Transfer Pricing- Basic Principles:

Transfer price is defined as ‘The price at which goods or services are transferred from one process or department to another or from one member of a group to another. The extent to which costs and profits are covered by the price is a matter of policy. A transfer price may, for example, be based upon marginal cost, full cost, market price or negotiation.’ – CIMA Official Terminology.

According to this definition, transfer price refers to the amount used in accounting for transfer of goods or services from one responsibility centre to another or from one com­pany to another which belong to the same group, Therefore, price used for accounting of transfer of finished goods from manufacturing department to marketing department can also be referred to as transfer price.
Similarly, price used for accounting of any cross-border transfer of goods or services from one company to another company which is a member of the same group is termed as ‘international transfer price’. However, the term transfer price is used to refer to the amount used in accounting for any good transferred from one division (profit centre or investment centre) to another.

Let us take an example. A multi-product firm manages its computer centre as a profit centre. The transfer price for services provided by the computer centre to other responsibility centres is accounted for as its revenue. Other responsibility centres treat transfer prices of services received by them as their costs.

Transfer pricing is a mechanism for distributing revenue between different divisions which joint­ly develop, manufacture, and market products and services.

Transfer pricing systems are designed to accomplish the following objectives:

(a) To provide each division with relevant information required to make optimal deci­sions for the organization as a whole.

(b) To promote goal congruence—i.e., actions by divisional managers to optimize divi­sional performance should automatically optimize the firm’s performance.

(c) To facilitate measuring divisional performances.

The method to determine the transfer price should fit in the organization structure. It should be simple to understand and easy to administer. It should ensure minimum interventions by the top management and autonomy of the sub-unit.

In a decentralized organization each division is viewed as an independent business unit and therefore a transfer price usually includes an element of profit. The term price is used in the same sense as is used in connection with sale and purchase by independent firms.

A transfer pricing system provides rules for setting transfer prices without interventions by corporate management. It also facilitates sourcing decisions, i.e., decisions on whether to procure the goods and services from another division or from external vendors. Sourcing decisions also refer to decisions to sell to another division or to an external buyer.

Usually, divisions enjoy autonomy as regards sourcing decisions. However, in certain situations corporate management impose restrictions on sourcing decisions.

The fundamental principle is that 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.

The following conditions must exist for most effective operation of a transfer pricing system:

(a) Competent People:

Ideally, managers should be interested in the long-run as well as short-run performances of their responsibility centres. Managers involved in negotia­tion and arbitration on transfer prices must be competent.

(b) Good Atmosphere:

Managers must regard profitability as measured in their income statement as an important goal and as a significant consideration in evaluating their performance. They should perceive that transfer prices are fair.

(c) A Market Price:

The ideal transfer price is based on a well-established, normal market price for the identical product being transferred—that is a market price reflecting the same conditions (quality, quantity, delivery time, and the like) as the product to which the transfer price applies.

The market price may be adjusted downward to reflect savings accruing to the selling unit from dealing inside the company. E.g., there would be no bad debt expense and smaller advertising and selling costs when products are transferred from one sub-unit to another within the firm. Although less than ideal, a market price for a similar, but not identical product is better than no market price at all.

(d) Freedom to Source:

Alternatives should exist, and managers should be permitted to choose the alternative that is in their own best interest. The buying manager should be free to buy from the outside, and the selling manager should be free to sell outside. In these circumstances, the transfer price policy is simply to give the manager of each sub-unit the right to deal with either insiders or outsiders, at their discretion.

The market, thus, establishes the transfer price. The decision to deal inside or outside is also made by the market place. If buyers cannot get a satisfactory price from the inside source, they are free to buy from the market.

Classification of Transfer Prices:

These ideal situations rarely exist in practice and therefore firms use different methods for determining transfer prices.

These may be classified as follows:

1. Market-based transfer prices

2. Cost-based transfer prices

3. Negotiated transfer prices

1. Market-Based Transfer Prices:

This method provides optimum results when the market for the intermediate product is perfectly competitive and the selling division can sell its output either to insiders or outsiders and as long as the buying division can obtain all its requirements from either outsiders or insiders.

In such a situation the company as a whole has no additional cost of providing autonomy to divisions. E.g., if division A decides to sell its product at the market price of Rs 100 per unit and division B decides to buy the same product from market at the market price, net cash flow to the firm will be zero.

If the market for the intermediate product is imperfect, this system may lead to sub- optimal utilization of production capacity by the buying division. The transfer price will form an element of the total marginal cost and the buying division will restrict its output at the level where marginal cost becomes equal to the marginal revenue. Thus, the firm as a whole will lose an opportunity to improve its profit because actual marginal cost is lower than the transfer price.

Let us take an example. The intermediate product that the sub-unit A of a firm uses is produced by the sub-unit B of the same firm and another firm. The market price of the product is Rs 100 per unit, while the variable cost of production in sub-unit B is Rs 40 per unit. If the transfer price is fixed at Rs 100 per unit (the market price) the sub-unit A will consider Rs 100 per unit as a part of its marginal cost.

It will restrict the output at the level where marginal cost equals marginal revenue. If the sub-unit B has excess capacity, the decision of the sub-unit A is sub-optimal for the firm as a whole. Even in a situation where the sub-unit B has no excess capacity, i.e., it can sell its total output to outsiders at Rs 100 per unit, the decision of the sub-unit A to restrict its output at a level lower than its achievable capacity might be sub-optimal for the firm as a whole.

Assume that the firm earns a contribution of Rs 100 per unit on the final product, the output of the sub-unit A. The contribution is higher than the contribution of Rs 60 per unit on the intermediate product. The firm loses the opportunity to earn higher profit by using the intermediate product internally in the sub-unit A instead of selling the same to outsiders.

Sourcing Decisions:

Ideally, divisional managers should have the freedom to make sourcing decisions but in certain situations corporate management imposes restrictions on sourcing decisions. One such situation is when markets for the buying or the selling divisions are limited. If most of the large companies are integrated, it is unlikely that any significant production ca­pacity for intermediate products would be available outside integrated firms.

Moreover, integrated firms, not being regular buyers from the market, may not have access to these independent manufacturers. This limits the market for the buying division. Similarly, if the intermediate product is a proprietary item of the company, no outside capacity exists. There might be a situation where freedom of sourcing is not granted to divisional manag­ers because the company has made significant investment in facilities.

In a situation of excess or shortage of industry capacity, firms tend to impose restric­tions on sourcing decisions. When the selling division has an excess capacity, the company will fail to optimize profits if the buying division purchases the intermediate product from outside. Conversely, when there is shortage of capacity in the industry, and the buying division is not able to meet its requirement from outside sources, the company may not be able to optimize profits if the selling division sells its product to outsiders.

However, companies often prefer not to impose any restriction on sourcing deci­sion, particularly if the situations described above are temporary. They build an arbi­tration mechanism within the transfer pricing system and allow divisions to appeal against sourcing decisions of other divisions.

Moreover, prudent and competent divi­sional managers of the affecting divisions take recourse to negotiation mechanism to negotiate with the concerned division to settle the sourcing issue. Thus, companies which do not impose restrictions on sourcing decision deal with situations of limited markets and excess or shortage of industry capacity through arbitration and negotia­tion mechanisms.

Establishing the Market Price:

A division which regularly sells its products to outside customers does not face any dif­ficulty in establishing market prices. Similarly, if list prices of identical or similar prod­ucts being manufactured by others are available, divisions find it easy to establish market prices. Market prices may also be set by bids. However, a firm can obtain serious bids only if it procures some quantity from the lowest bidder. A firm which invites bids just to establish market prices is more likely to get frivolous bids.

Even if the market price of an intermediate product is not available, divisions establish competitive prices, which form the basis for determining transfer prices. Divisions set competitive prices by replicating market prices from available information. E.g., if published price is available only for short-term deals, such prices are adjusted for long-term commitments for determining the competitive price.

Similarly, if a buying division purchases similar products from the outside, it is possible to replicate market prices for proprietary products. If a selling division normally earns a return of say 10% over standard cost it can establish the competi­tive price by adding 10% on the standard cost of the proprietary product.

Occasionally an industry experiences a period of significant excess capacity and ex­tremely low prices, which are often termed as ‘distress market prices’. Distress pricing is a temporary phenomenon. It is often difficult to judge whether the current market price is a distress price. Many firms continue to use the current market price, which is a distress market price, for setting the transfer price.

Many other disregard the distress market price and set the transfer price based on the long-term ‘normal’ market price. If the firm sets the transfer price based on the distress price, the selling division might stop the production of the intermediate product. This decision might be contrary to the long-term objective of the firm.

On the other hand, if the buying division is compelled to buy at the normal market price, which is higher than the current market price, its short-term performance will be adversely affected. However, the use of the normal market price helps to assess the viability of the selling sub-unit.

To conclude, market-based transfer prices work best when the market for the inter­mediate product is perfectly competitive. In other situations it provides satisfactory results provided intermediate products are available on competitive prices. In all other situations there is no option but to use cost-based transfer prices.

2. Cost-Based Transfer Prices:

If competitive prices are not available or it is too costly to obtain market prices, transfer prices may be determined based on the cost plus profit. Cost-based transfer prices should be used only as a second option to market-based transfer prices because it involves complex calcula­tions and results are less than satisfactory.

It is always preferable to use standard cost because use of actual costs may result in passing inefficiencies of the selling sub-unit to the buying sub-unit. However, it is neces­sary to set tight standards and provide incentive to improve standards.

Profit markup should be based either on cost or on investment. Irrespective of the base selected (full cost or variable cost) the markup should approximate the return that an independent company manufacturing similar product expects to earn by selling its products to outside customers.

Usually, companies use full cost for setting transfer prices. However, this creates the problem of asymmetric information and the buying division may not have the informa­tion on the amount of upstream fixed costs and profit included in the transfer price. This might result in pricing decisions, which fail to optimize the firm’s profit.

Even if full information is available to the division it may not reduce its profit margin for improving profit of the firm as a whole. Thus, full cost-based transfer price might fail to achieve goal congruence between the division and the firm.

Firms endeavour to solve this problem by adopting two-step pricing. Under this method full cost is segregated into variable costs and fixed costs. Both variable costs and fixed costs may include profit markup. Total variable costs are charged to the purchasing division depending on the actual number of units actually transferred by the selling divi­sion.

Fixed costs (lump sum) are charged periodically based on the capacity reserved by the selling division to cater to the needs of the buying division. E.g., division A purchases product P from division B. A has estimated its monthly requirement of P at 5,000 units per month. B has reserved a part of its manufacturing capacity for A and has assigned fixed costs of CU 20,000 per month to the reserved capacity. Therefore (if variable cost per unit of P is CU 5, the full cost is CU 5 + (CU 20,000/5,000), i.e. CU 9 per unit).

If actual transfer in any month equals the estimated quantity of 5,000 units, division A will be charged CU 45,000 for the transaction. Under full cost method the amount will be calculated as CU 9 × 5,000, i.e., Rs 45,000. Under two-step pricing the amount will be calculated as CU 5 × 5,000 + CU 20,000 = CU 45,000. Both the methods produce the same result only if actual transfer exactly matches the estimated demand.

If actual transfer is short or excess of the estimated demand the amount to be charged under two-step pricing will differ from the amount to be charged if full cost method is used for calculating the price. E.g., if actual transfer in a particular month is 4,000 units, amount to be charged to the division A will be CU 5 × 4,000 + CU 20,000 that is CU 40,000 under the two-step pricing method, while CU 9 × 4,000, i.e., CU 36,000 will be charged under full cost pricing methods.

Two-step pricing method is similar to the ‘take or pay’ pricing that is frequently used in public utili­ties, pipelines, coal mining, and other long-term contracts.

Where two-step transfer pricing system is not feasible, goal congruence is achieved by adopting a system in which the product is transferred at standard variable cost and each division is credited with a prorated share of the actual contribution earned. This method, which is known as profit sharing method is appropriate where the buying division can­not estimate the demand of the product in advance and consequently the selling division cannot reserve a part of its capacity for manufacturing the product.

There are practical problems in operationalizing the system. First, it is often difficult to arrive at a mutually agreed basis for sharing the contribution and corporate management intervenes to arrive at a settlement. Such interventions are costly and defeat the very basic objective of de­centralization.

Second, arbitrary allocation of contribution impairs the measurement of divisional profitability. Third, actual contribution depends on actual market realization and therefore the selling division may consider the method unfair.

Some companies use dual pricing method. In this method the selling division is credited at the outside selling price or with an amount calculated by adding a markup to the full cost, and the buying division is charged the total standard cost. The difference between the two transfer prices is debited to the corporate account and eliminated while consolidating divisional accounts.

The dual pricing method is not popular because it gives an illusive feeling that the different business segments are profitable while some segments might be losing money. Moreover, this method does not provide enough incentives for cost management. It conceals market information from the buying sub-unit. Some experts feel that the method reduces conflict between the selling and buying divisions even below the conflict level that is healthy in the sense that it signals potential problems.

3. Negotiated Transfer Price:

In most companies, the management designs a transfer pricing system which provides basic policies and guidelines for setting transfer prices; business divisions negotiate transfer prices within those parameters. The most important reason for this is that each division is perceived as an independent business unit and therefore divisional managers are allowed to decide what is best for their divisions.

In most situations pricing and sourcing decisions require some degree of subjective judgment and negotiation results in some form of com­promise between buyer and seller divisions. Negotiations may be based on market-based transfer prices or cost-based transfer prices depending on the company practices.

Transfer pricing system must have inbuilt mechanisms for smooth negotiation and conflict resolution. In absence of these mechanisms, negotiations would cause more harm than good to the company. However, it is important that only a few disputes be submitted to arbitration because arbitration price satisfy neither the buying division nor the selling division.

Moreover, arbitration process is time consuming and costly. Submission of large number of appeals for arbitration signals something wrong in the system which should be remedied at the earliest.

General Transfer Pricing Rule:

The following general guideline is helpful in setting the transfer price:

Minimum transfer price = Incremental cost per unit incurred up to the point of transfer + Opportunity cost per unit to the selling sub-unit

Incremental cost means the additional cost of producing and transferring the products or services. Opportunity cost is the maximum contribution margin foregone by the selling sub-unit.

Let us take an example to illustrate the general rule. Assume that the sub-unit A is the buying sub-unit and the sub-unit B is the selling sub-unit. Assume further that the incremental cost incurred by the sub-unit B up to the point of transfer is CU 20. The opportunity cost per unit of internal transfer to the sub-unit B will be different under different market situations.

Let us consider the following situations separately:

(a) A Perfectly Competitive Market for the Intermediate Product:

Assume that the market price of the product is CU 32. Usually under a situation of perfect competition the sub-unit B should not have any surplus capacity. Theoretical­ly, it should be able to sell whatever it produces at Rs 32. Therefore, the opportunity cost of transferring the product internally to the sub-unit A is (CU 32-20) or CU 12. Therefore, as per the general guideline the minimum transfer price should be fixed at (CU 20 + 12) or CU 32 which is equal to the market price.

Assume that the sub-unit A receives an offer from an external source to supply the product at Rs 29 per unit as an introductory offer. The sub-unit A decides to buy from the external source because the price is lower than the transfer price. The decision of the sub-unit A will improve the profitability of the firm. The sub-unit A will improve the contribution per unit of the final product due to lower material cost.

The sub-unit B will continue to earn a contribution of Rs 12 per unit on its total output. Therefore, when a perfectly competitive market exists, the market price should be the transfer price. However, if the incremental cost per unit for internal supply is lower than the incremental cost per unit for the external supply, the market price may be adjusted for the saving.

(b) The Market for the Intermediate Product is Not Competitive and the Selling Division has Idle Capacity:

The market for the intermediate product is not competitive. Therefore, firms are not price takers. The sub-unit B should be able to sell more units by reducing the price of the product. Therefore, the opportunity cost per unit is different at different output level.

In most situations, it is difficult to precisely estimate the opportunity cost per unit at different output levels. The solution is to allow the buying division and the selling division to negotiate the transfer price. Perhaps both the divisions will agree to a schedule of transfer prices for different output levels.

(c) No External Market for the Intermediate Product:

In absence of an external market the selling division (sub-unit B) has no opportunity to sell its product outside the firm. Therefore, there is no opportunity cost for transferring the product internally to the sub-unit A. Thus, in accordance with the general transfer pricing rule the sub-unit B should transfer the product to the sub-unit A at the incremental cost per unit.

If the market for the final product is not competitive, transfer of the intermediate product by the sub-unit B to the sub-unit A at the incremental cost per unit will maximize the profit of the firm. The marginal cost of the final product (produced by the sub-unit A) for the sub-unit A will be the same as the marginal cost for the firm. Therefore, the quantity (at marginal cost = marginal revenue) that sub-unit A will produce and sell will be the quantity at which the profit for the firm overall is the maximum.

If the market for the final product is competitive, the sub-unit A will produce as many numbers as it can produce and the sub-unit B will supply to the sub-unit A as many numbers of the inter­mediate product as is required by A. This will maximize the profit of the firm.

International Transfer Price and Tax Considerations:

Although the general transfer pricing rule is applicable to transfer of goods and services between two units or two associated firms located in differ­ent countries, often multinational firms violate the rule to minimize total tax liability of the group. Multinational firms set the transfer price taking into consideration the impact of the transfer price on direct and indirect taxes.

Let us take an example of income tax. Assume two units of a multinational corporation are located in two countries A and B. Assume that their income tax rate in country A is 40% and that in country B is 30%. The multinational corporation will be tempted to transfer profit of the unit located in country A to the unit located in country B.

Accordingly it will fix the transfer price of the product being transferred from the unit in country A below the market price. Similarly it will fix the transfer price of the product being transferred from the unit located in country B above the market price. However, in most countries tax law prohibits such manipulations.

The Indian Income Tax Act 1965 provides a statutory framework that can lead to computation of reasonable, fair, and equitable profits and tax of associates or units of mul­tinational enterprises located in India. Chapter X (Section 92 and 93) provides that any income arising from an international transaction shall be computed having regard to the arm’s length price.

Similarly, the allowance for any expense or interest arising out of inter­national transaction shall be determined having regard to the arm’s length price. However, provisions for arm’s length price shall not apply if these result into reduction of income or increase of loss. ‘Arm’s length price’ means a price which is applied or proposed to be ap­plied in a transaction between persons other than associated enterprises, in uncontrolled conditions.

The Income Tax Act provides various methods to determine the arm’s length price.

In view of increasing protection against avoidance of tax by using transfer price, it is appropriate for multinational enterprises to fix transfer price with an aim to achieve goal congruence.

Summary:

Many companies select decentralized organization structures to implement their strategies. In a decentralized structure, decision-making powers are vested with managers who are clos­er to business situations. Divisionalization of the company has emerged as the most popular technique for decentralization. Divisions are treated as profit centres or investment centres and autonomy is granted to divisional managers to manage their business as an independent business.

However, the degree of autonomy depends on the nature of the business and the strategy of the firm. The success of divisionalization depends on the effectiveness of divi­sional performance measurement. RI (EVA) method is considered to be a superior method for measuring divisional performance as compared to ‘ROI’ method.

Transfer of goods and services between divisions is not unusual. Pricing of these trans­fers poses complex problems because a wrong pricing method may misstate divisional profits and may kill entrepreneurial spirit of divisional managers. Moreover, it may induce managers to select those alternatives which would improve divisional profit even if they fail to optimize company profit. In setting the transfer pricing mechanism firms’ aim to achieve goal congruence while motivating managers to optimize performance.

However, in certain situations corporate management may not give complete independence to divisional manages in deciding whom to sell and from where to buy. Market- based transfer pricing systems do not provide satisfactory results if intermediate market does not exist or competitive prices cannot be established.

In those situations, companies use cost-based transfer prices. In practice companies use many variations of cost-based prices but none of them provides satisfactory results. Therefore, cost-based system is al­ways a second choice, whereas market-based system is the first.

A transfer pricing system should have inbuilt mechanisms for negotiation and conflict resolution. Corporate provides guidelines and parameters for setting transfer prices and divisional managers are allowed to negotiate between themselves. Negotiations lead to com­promise decisions, which optimize divisional and company profits in the given situation.