Transfer pricing

What is transfer pricing?

The determination of an exchange price The determination of an exchange price when different business units within a when different business units within a firm exchange products or services firm exchange products or service

Objectives of transfer pricing?

To motivate managers; to provide an incentive for managers to make decisions consistent with the firm's goals; to provide a basis for fairly rewarding the managers.

International problems of transfer pricing

1. Minimization of Customs Charges; 2. Currency Restrictions; 3. Risk of expropriation

Transfer price

The amount charged when one division of an organization sells goods or services to another division. The exchange is internal and does not affect the organization’s total sales or profit.

Impact of Transfer Pricing on Organizations

If the divisions are evaluated on profitability, the transfer price can have an impact on the reported performance of each division.

Setting transfer prices

The value placed on the goods being transferred between divisions should encourage the divisions to complete the transfers, if that is in the organization’s best interest while allowing the organization’s best interest – while allowing them to retain their autonomy.

What is the goal in setting the transfer price?

to provide incentives for each division manager to act in the company’s best interests.

Why the general rule is often difficult or impossible to implement?

the difficulty of measuring opportunity costs.

What transfer pricing methods do we have?

variable cost, full cost, market price, negotiated price

What is variable cost method?

sets the transfer price equal to the variable cost of the selling unit

What is full cost method?

sets the transfer price as the variable cost plus allocated fixed cost for the selling unit

What is negotiated price method?

involves a negotiation process and sometimes arbitration between units to determine the transfer price

What is market price method?

Sets the transfer price as the current price for the selling unit’s product in the market

Transfer based on the external market prices?

1. If the transfer price is set at market price, the producing division should have the option to either produce goods for internal transfer or sell in the external market. 2. The buying division should be required to purchase goods from inside its organization if the producing division’s goods meet the product specifications. 3. Otherwise, the buying division should have the autonomy to buy form a supplier outside its organization.

Distress market prices

Occasionally an industry experiences a period of significant excess capacity and extremely low prices.

Negotiated transfer prices

In some companies, division managers negotiate the price at which transfers will be made.

What are the threats of negotiated transfer prices?

Negotiations can lead to divisiveness and to competition between participating division managers; Although negotiating skill is a valuable managerial skill, it should not be the sole or dominant factor in evaluating a division.

What are cost based transfer prices?

When a company does not use market prices or negotiated prices to determine transfer price, it usually turns to cost-based transfer-pricing.

The cost-based transfer price may be The cost based transfer price may be based upon:

1. Unit-level cost 2. Absorption cost

Using Standard Unit-Level Cost

When using this approach, the producing division is not allowed to show any contribution margin on the transferred products or services. Under such conditions, the producing, the producing division has no positive incentive to produce and transfer products or services efficiently.

Using absorption cost

Absorption cost is equal to the product’s unit- level cost plus an assigned portion of the higher-level costs (batch-level, product-line- level, customer-level, and facility-level costs).

Standard versus Actual Costs

Transfer prices should not be based on actual costs because such a practice would allow an inefficient producing division to pass its excess production costs on to the buying division via the transfer price.

Remedying Motivational Problems of Transfer Pricing Policies

Consider treating the selling division as a cost center; Consider treating the selling division as a profit center for external sales and a cost center for internal transfers; Use these criteria when evaluating division performance.

What is the dual transfer pricing system?

A dual transfer-pricing system charges the buying division for the cost of the transferred product (however the cost might be determined) and credits the selling division with the cost plus some profit allowance.

Advantage of Variable Cost Method?

Causes buyer to act as desired, to buy inside.

Limitation of Variable Cost Method?

Inappropriate for long-term decision making; unfair to seller if seller is profit or investment SBU.

What are the advantages of full cost method?

Easy to implement; intuitive and easily understood; Preferred by tax authorities over variable cost; Appropriate for long-term decision making

What are the limitations of full cost method?

Irrelevance of fixed cost in decision making; fixed costs should be ignored in the buyer's choice of whether to buy inside or outside the firm. If used, should be standard rather than actual cost

What are the advantages of market price method?

Helps to preserve unit autonomy; Provide for the selling unit to be competitive with outside suppliers with; Has arm’s-length standard desired by standard taxing authorities

What are the limitations of market price method?

Should be adjusted for Should be adjusted for cost savings such as reduced selling costs, no commissions; often intermediate products have no market price

What is the advantage of negotiated price method?

May be most practical approach when there is significant conflict.

What are the limitations of negotiated price method?

Potential tax problems may not be considered arm’s length; need negotiation rule and/or arbitrations procedure and this may reduce autonomy.

International Tax Issues in Transfer Pricing - what are the methods?

There are three widely used methods: The comparable price method; The resale price method; The cost-plus method

Setting transfer prices

A good should be transferred internally whenever the opportunity cost (minimum price) of the selling division (minimum price) of the selling division is less than the opportunity cost (maximum price) of the buying division.

What companies do need to report about the segments?

Revenue; Operating profits or losses.; Operating profits or losses.; Identifiable segment assets.; Depreciation and amortization.; Capital expenditures.; Certain specialized items.

If a company has significant foreign operations, it must disclose...

Revenues; Operating profits or losses. Operating profits or losses; Identifiable assets by geographic region.