Transfer PricingTransfer Pricing

ByByPunit Kumar DwivediPunit Kumar Dwivedi

(AIMA)(AIMA)BBCITBBCIT

DefinitionDefinition

Value placed on transfers within an organization, Value placed on transfers within an organization, used as a means of allocating costs to various profit used as a means of allocating costs to various profit centers is transfer pricing.centers is transfer pricing.

The price at which divisions of a company transact The price at which divisions of a company transact with each other. Transactions may include the trade of with each other. Transactions may include the trade of supplies or labor between departments.supplies or labor between departments.

Transfer prices are used when individual entities of Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as a larger multi-entity firm are treated and measured as separately run entities. separately run entities.

Objectives of TPObjectives of TP1.1. It should provide each business unit with the It should provide each business unit with the

relevant information.relevant information.2.2. It needs to determine optimum trade off It needs to determine optimum trade off

between companies cost and revenue.between companies cost and revenue.3.3. It should induce the goal congruence It should induce the goal congruence

decision to improve units profit.decision to improve units profit.4.4. It should help to measure the economic It should help to measure the economic

performance of individual business unit.performance of individual business unit.5.5. The system should beThe system should be simple simple to understand to understand

and and easyeasy to administer. to administer.

Criteria for validity & acceptability of Criteria for validity & acceptability of TPTP

1.1. TP should be objectively determined.TP should be objectively determined.

2.2. TP should be equal to the value of the TP should be equal to the value of the intermediate product being transferred.intermediate product being transferred.

3.3. TP should be compatible with a policy that TP should be compatible with a policy that maximises attainment of the companies goal and maximises attainment of the companies goal and evaluation of segments performance.evaluation of segments performance.

Factors affecting TP Factors affecting TP Performance measurement.Performance measurement.

Capability of accounting system.Capability of accounting system.

Inport quotas.Inport quotas.

Custom duties.Custom duties.

VAT.VAT.

Taxes on profitTaxes on profit

Uses of TPUses of TP1)1) Price setting for services performed by Price setting for services performed by

business unit.business unit.

2)2) A mean of evaluating financial performance of A mean of evaluating financial performance of business unit.business unit.

3)3) Determining the contribution to net profit by Determining the contribution to net profit by profit centers in org.profit centers in org.

4)4) Reduce in corporate taxes paid.Reduce in corporate taxes paid.

5)5) Reduce in VAT , excise, tariffs.Reduce in VAT , excise, tariffs.

Fundamental PrincipleFundamental Principle1.1. The transfer price should be similar to The transfer price should be similar to

the price that would be charged if-the price that would be charged if- The product were sold to outside The product were sold to outside

customers orcustomers or Purchased from vendorsPurchased from vendors..

TP policiesTP policies That refers to selection of policies that That refers to selection of policies that

would govern the calculations of such would govern the calculations of such prices under various circumstances. prices under various circumstances.

The concern of TP policies are with The concern of TP policies are with developing a TP system that allows-developing a TP system that allows-

1)Performance measurement1)Performance measurement2)Decision optimization2)Decision optimization a) Optimal utilization of resourcesa) Optimal utilization of resources b) Cost of goodsb) Cost of goods c) Services transferred between unitc) Services transferred between unit d) Opportunity cost, mkt. priced) Opportunity cost, mkt. price

Fundamental decisionsFundamental decisions Should the company produce the product Should the company produce the product

inside the company or purchase from out inside the company or purchase from out side vendor ?side vendor ?

This is sourcing decision.This is sourcing decision.

If produced inside at what price should the If produced inside at what price should the product be transferred between profit product be transferred between profit centers? centers?

This is transfer pricing decision.This is transfer pricing decision.

Transfer PricingTransfer Pricing

A transfer price is the price one subunit chargesfor a product or service supplied to another

subunit of the same organization.

Intermediate products are the productstransferred between subunits of an organization.

Transfer-Pricing MethodsTransfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices

Negotiated transfer prices

Transfer-PricingTransfer-PricingMethods ExampleMethods Example

Lomas & Co. has two divisions:Transportation and Refining.

Transportation purchasescrude oil in Alaska and

sends it to Seattle.

Refining processescrude oil

into gasoline.

Market-Based Transfer PricesMarket-Based Transfer Prices

By using market-based transfer pricesin a perfectly competitive market, acompany can achieve the following:

Goal congruence

Management effort

Subunit performance evaluation

Subunit autonomy

Market-Based Transfer PricesMarket-Based Transfer Prices

Market prices also serve to evaluate theeconomic viability and profitability

of divisions individually.

Cost-Based Transfer PricesCost-Based Transfer Prices

If competitive prices are not available transferprices may be set on the basis of Cost-Plus a profit.Two decisions must be made in a cost based TP sys.1)How to define cost.2)How to compute the profit markup.The usual basis is standard costs.Actual cost should not be used because production inefficiencies will be passed on to the buying profit center.

TP & profit share systemTP & profit share system

This system operates as follows:-1)The product is transferred to marketing unit atStandard variable cost. 2)After selling of product the business unitShares the contribution earned which is Selling price-VC& marketing cost.

Problems of profit sharing systemProblems of profit sharing systemArgument over the way of deviding profitsbetween two profit centers.Arbitrary dividing up the profit between unitsdoes not gives valid information on the profit-ability of each unit.The mfg. units contribution depends upon the marketing units ability.Manufacturing unit may perceive this unfair bad situation.

RecommendationsRecommendations

If competitive prices are not available , TP may set on the basis of cost plus profit, eventhough such TP may be complex to calculateand the results less satisfactory than a market based price. Cost based TP can be made at std.Cost +PROFIT margin, or by the use of TWO-STEP PRICING SYSTEM.In tsps the mfg.units revenue is credited at the Outside sales price and the buying unit is chargedThe total std. cost. The difference is charged to HQ.

ANY QUESTIONS ?ANY QUESTIONS ?

Thank YouThank You

All the BestAll the Best