Scribd
Upload
438 views4 pages

Alternative Methods of Transfer Pricing

Transfer pricing refers to the prices charged for transactions between different divisions of the same company. It is an important issue when companies decentralize decision making through profit centers. The transferring division wants to charge the maximum price while the receiving division wants to pay the minimum. Transfer prices should not negatively impact overall company profits and should be in the company's best interest. Common transfer pricing methods include market-based, negotiated, and cost-based approaches. Decentralization has advantages like timely local decisions but also disadvantages like lack of goal congruence and coordination between divisions.

Uploaded by

Ryan Franklin
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
438 views4 pages

Alternative Methods of Transfer Pricing

Transfer pricing refers to the prices charged for transactions between different divisions of the same company. It is an important issue when companies decentralize decision making through profit centers. The transferring division wants to charge the maximum price while the receiving division wants to pay the minimum. Transfer prices should not negatively impact overall company profits and should be in the company's best interest. Common transfer pricing methods include market-based, negotiated, and cost-based approaches. Decentralization has advantages like timely local decisions but also disadvantages like lack of goal congruence and coordination between divisions.

Uploaded by

Ryan Franklin
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
You are on page 1/ 4

CONCEPT:

A transfer price is the price of an intra-firm transaction. It is the price charged for transfer of goods and services from one segment of the firm another of the same firm. Transfer pricing therefore refers to the setting of prices at which transactions occur involving the transfer of goods or services between different entities of the same company or group. Transfer prices serve to determine the income of both entities involved. Transfer Pricing concept attain importance when the firms decentralize through profit centers. The manager of each department is responsible for the performance of his department. Each department tries to maximize its profit. The transferor department wants to charge the maximum price for what is being transferred. The transferee department wants to pay the minimum for the same. The determination of transfer price is guided by three principles: (i) Transfer price should not have adverse impact of the profits of the company as a whole; pricing decisions should be in the best interest of the firm. (Remember the ultimate aim is to maximize the profits of the company as a whole. In case the transferor and the transferee are not able to negotiate the mutually satisfactory transfer price, the central management may interfere if it is necessary for maximize the profit of the company as a whole). The other two rules, given below, are subordinates of this rule. Minimum Transfer Price = cost to be incurred by the transferor + Benefit lost to be by the transferor Maximum Transfer price is the cost to be incurred by the transferee in case of external buy.

(ii) (iii)

FEATURES OF TRANSFER PRICING:


A sound transfer pricing policy is one that meets the following objectives: Goal congruent :Encourages transacting managers to make goal congruent decisions i.e. decisions should be in the best interest of the firm Motivation :Fairly rewards transacting managers for their contribution to company profits, Autonomy: Maintains transacting managers autonomy. Performance Evaluation: Should be able to measure the performance of transacting managers. Provides basis for suitably rewarding the transacting managers. Co-ordinates production, sales and pricing decisions of different divisions. Should be simple to implement

Alternative Methods of Transfer Pricing


A transfer pricing policy defines rules for calculating the transfer price. In addition, a transfer price policy has to specify sourcing rules (i.e., either mandate internal transactions or allow divisions discretion in choosing whether to buy/sell externally). The most common transfer pricing methods are described below.

1) Market-based Transfer Pricing:


When the outside market for the good is well-defined, competitive, and stable, firms often use the market price as an upper bound for the transfer price. Concerns with market-based Transfer Pricing When the outside market is neither competitive nor stable, internal decision making may be distorted by reliance on market-based transfer prices if competitors are selling at distress prices or are engaged in any of a variety of special pricing strategies (e.g., price discrimination, product tie-ins, or entry deterrence). Also, reliance on market prices makes it difficult to protect infant segments.

2) Negotiated Transfer Pricing:


Here, the firm does not specify rules for the determination of transfer prices. Divisional managers are encouraged to negotiate a mutually agreeable transfer price. Negotiated transfer pricing is typically combined with free sourcing. In some companies, though, headquarters reserves the right to mediate the negotiation process and impose an arbitrated solution. 3) Cost-based Transfer Pricing: In the absence of an established market price many companies base the transfer price on the production cost of the supplying division. The most common methods are: Full Cost Cost-plus Variable Cost plus Lump Sum charge Variable Cost plus Opportunity cost Dual Transfer Prices Each of these methods is outlined below. a) Full Cost: A popular transfer price because of its clarity and convenience and because it is often viewed as a satisfactory approximation of outside market prices. (i) Full actual costs can include inefficiencies; thus its usage for transfer pricing often fails to provide an incentive to control such inefficiencies. (ii) Use of full standard costs may minimize the inefficiencies mentioned

above. b) Cost-plus: When transfers are made at full cost, the buying division takes all the gains from trade while the supplying division receives none. To overcome this problem the supplying division is frequently allowed to add a mark-up in order to make a reasonable profit. The transfer price may then be viewed as an approximate market price. c) Variable Cost plus a Lump Sum Charge: In order to motivate the buying division to make appropriate purchasing decisions, the transfer price could be set equal to (standard) variable cost plus a lump-sum periodical charge covering the supplying divisions related fixed costs. d) Variable Cost plus Opportunity Cost: Minimum Transfer Price = Incremental Cost + Opportunity Cost. For internal decision making purposes, a transfer price should be at least as large as the sum of: cash outflows that are directly associated with the production of the transferred goods; and, the contribution margin foregone by the firm as a whole if the goods are transferred internally. Sub-optimal decisions can result from the natural inclination of the manager of an autonomous buying division to view a mix of variable and fixed costs of a selling division plus, possibly, a mark-up as variable costs of his buying division. Dual transfer pricing can address this problem, although it introduces the complexity of using different prices for different managers. e) Dual Transfer Prices: To avoid some of the problems associated with the above schemes, some companies adopt a dual transfer pricing system. For example: Charge the buyer for the variable cost. The objective is to motivate the manager of the buying division to make optimal (short-term) decisions. Credit the seller at a price that allows for a normal profit margin. This facilitates a fair evaluation of the selling divisions performance.

Advantages and Disadvantages of Decentralization:


Advantages: Decisions are better and more timely because of the managers proximity to local conditions. Top managers are not distracted by routine, local decision problems. Managers motivation increases because they have more control over results. Increased decision making provides better training for managers for higher level positions in the future.

Disadvantages: Lack of goal congruence among managers in different parts of the organization. Insufficient information available to top management; increased costs of obtaining detailed information. Lack of coordination among managers in different parts of the organization. Obtaining specialized (or local) information is costly. Communication of information is costly. There exist interdependencies between the decisions of different managers in terms of the outcome to the firm as a whole. The amount of information to be managed is extremely large. Transfer pricing is often complicated by imperfect, ill-structured, or nonexistent intermediate markets. Imperfect competition occurs when a single buyer or seller can influence the market price.

You might also like