Transfer Pricing Notes

APM Instructor - Rizwan Maniya
F9
TRANSFER PRICING
Transfer price is the price at which goods and services are transferred from one division to
another division within same organization in order to calculate each division's profit and loss
separately. It represents the revenue per unit from the supplying division and cost per unit for
receiving division. The purpose of transfer price is to motivate managers and to improve
divisional performance. However an incorrect transfer price might result in suboptimal
decision which will affect overall organization’s profitability.
Objectives of transfer pricing
Goal congruence Performance measurement Autonomy
Each profit center manager A properly set transfer price Profit center manger should
should make sure that their will enable the performance of have the autonomy when
decisions are in line with each division to measured and setting transfer prices for
company’s objectives in assessed. However an their divisions in order to
order to achieve goal incorrect transfer price will motivate them. However this
congruence. This is true create disputes between the might lead to suboptimal
because without a fair divisional mangers thus decisions for example trying
transfer price there might be making it difficult to measure to improve their own division
a disagreement as to how the true performance. performance at expense of
much work should be other divisions resulting in
transferred to internal self-interested segments.
division and much sales
should be made to external
market in order to maximize
the division’s profit.
Minimizing global tax liability A properly set transfer price will lead to fair
allocation of profits.
When setting a transfer price following things should be considered.
Goal congruence Performance measurement Autonomy
Types of transfer pricing
1. General rule (Theoretical transfer price)

Marginal cost + opportunity cost
Where opportunity cost will be either:
1. The contribution forgone by not selling the product externally. In this case the market price
will be equal to marginal cost plus the opportunity cost. However for this to take place it is
important that the competition should be a perfect competition.
2. The contribution loss by not using the resources on same other alternative use.
Exemption to the above rule
If there is spare capacity then the transfer price will be the marginal cost only as the
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F9
opportunity cost will not exist.
Practical transfer prices
2. Market prices
Market based transfer price will be considered as fair transfer price for all the managers and
will reduce the chances of dysfunctional behavior. However following are the problems
associated with market based transfer price:
1. No immediate market is available for the intermediate product resulting in no market price.
2. Publish market price are fictitious.
3. The transferring division has monopoly in the market.
3. Adjusted market prices

Transfer made internally will often result in cost saving when compared with external sales in
form of saving in selling, distribution, bad debts risk and administration cost. All such savings
will make it possible for the selling to give discount on the market price to buying division.
4. Cost based approach

Transfer price based on cost should only be based on standard cost and not on the actual cost
because in actual cost there is a risk that inefficiency of the supplying division will passed on
to the buying division.

F9
Key points to remember
1. For the receiving division the transfer price will be a variable cost but that
transfer price might include the fixed cost of the supplying division. So any
decline in the receiving division’s demand or receiving division giving preference
to external market will lead to under absorption of fixed overhead of the
supplying division.
2. As long as the divisions continues trading with each other so there are less
chances that the overall company profitability gets affected but any preference
given by the division to external market over the internal division there is a high
probability that the overall company’s profits will get affected.
Other transfer prices

1. Marginal cost plus lump sum (two part charging system)
The supplying division transfers the each unit to buying division at variable cost and
also receives a lump sum fixed fee in order to cover its fixed cost.
2. Dual pricing
Dual pricing means that two different transfer prices are used i.e. supplying division
records a transfer price based on full cost whereas buying division records a transfer
price based on marginal cost. This method ensures optimal decisions and avoid the
possibility of reporting losses however period end adjustment are required in the
accounts.
International transfer pricing

Multinational companies have different subsidiaries operating in different countries. So
almost two third of the world trade takes place within multi-national companies so it is
important to consider international transfer pricing. Following are the factors that should
be considered in international transfer pricing.
1. Taxation
A group having divisions in different countries will be subject to different tax rates. A
well set transfer price can save the global tax liability however artificial attempts to
reduce tax liabilities can give a signal to country’s tax authorities who have the power
to alter the transfer prices.
2. Import tariffs
The country in which buying division is situated might be subject to import tariffs so
a low transfer price can minimize the duty cost.
3. Exchange rates
A well set transfer price should consider currency exchange rate fluctuations.
4. Remittance controls
The country’s government in which buying division is situated might block the
remittance of dividend to parent company. A properly set transfer price can overcome
this problem if the selling division charges extraordinarily high prices from buying
division thus converting profits into revenues.

F9
TYPES OF TRANSFER PRICES USED IN MULTINATIONALS.

1. Market based transfer price will be seen as completely acceptable for the tax
authorities of both the countries but it have certain practical limitations.
A. Prices may vary between different countries.
B. Changes in exchange rates will affect the transfer prices
C. Prices may be set considering demand and supply situation.
2. A full cost transfer price will be considered acceptable for tax authorities as it gives
them some indication that it approximates to the real cost of supplying division.
3. A transfer price based on variable cost will not be acceptable for the tax authorities of
the supplying division country because it will transfer all the profit to buying division
and will show losses in supplying division.


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APM Instructor - Rizwan Maniya

Goal congruence Performance measurement Autonomy

Types of transfer pricing

1. General rule (Theoretical transfer price)

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Practical transfer prices

3. Adjusted market prices

4. Cost based approach

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Other transfer prices

International transfer pricing

Virtual Institute For Higher Education

TYPES OF TRANSFER PRICES USED IN MULTINATIONALS.

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