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Introduction to Transfer Pricing

Describe about the Business Transfer Pricing Methods.

Part A

Transfer price is the price at which goods or/and services are bought and sold (transferred) between divisions of the same corporations. For example, in an automobile manufacturing company, if the subsidiary which manufactures tires sells them to the parent company, the price paid by the parent company for the tires is called the transfer price. The divisions of a large multi-department company can be treated as separately run companies with the use of transfer pricing.

In contemporary accounting, different divisions of an organization are run as profit-centers, i.e they are accountable for their own profits. Now if a division transfers it’s goods to another division of the same company, what price should it use to determine its contribution margin? Similarly, if a division accepts transfers from another division, what cost should reflect on its profit and loss statement for these goods? A transfer price is used to determine these prices and costs. (Schuster, 2010)

Different divisions of a company may be located in different countries with different tax norms. A company may use transfer pricing to lower its tax liabilities by lowering the profits of divisions located in countries with higher taxes. Similarly, it can raise profits of divisions which are located in countries with lower tax-rates, also known as tax havens. Therefore, there are regulations put in place by various governments on transfer pricing to curb corporate tax avoidance. (Chand, 2014)

Transfer prices can be of following types:

Market based transfer price: In this type of transfer pricing, transfer price is set equal to the market price of the product that is transferred. Such kind of transfer pricing is used when the market is “perfect” for the product that is transferred i.e

The product should be homogenous i.e there should not be similar products with difference in quality. It should be as close to a commodity as possible. For example the capacitors that are used in a television are very close to a commoditized transferred product.

There should only be one price of the product in the market for both the buyer and the seller. The seller should be able to sell the product in the market at the same price at which the buyer is expected to purchase that product in the market, at the least. For example, if the seller can sell the product at $90 in the market, the buyer should have to pay at least $90 in the market to buy the product.

There should be no variable buying or selling costs. It should not be the case that if the seller wants to sell the product in the market instead of transferring it to the buyer, he has to incur an extra selling cost. Similarly, it should not happen that if the buyer wants to buy the same product in the market rather than transfer it from the seller, he has to incur excess transactional costs.

The selling division should be operating at full capacity and should able to sell whatever quantity of product it is producing. In this case, the seller will have to forego external sales if it transfers any amount of product to the buyer. In order to compensate for the opportunity cost, the amount lost due to loss of external sale should be included in the transfer price. Thus, transfer price is equal to the market price. (Burkadze, 2016)

Types of Transfer Pricing

In this type of transfer pricing, the minimum transfer price would be equal to the maximum transfer price and both the seller and the buyer would be happy with the market price as being the transfer price. This transfer pricing will help in providing a good basis for performance evaluation and reduce the animosity between divisions.

However, such a kind of transfer pricing is rarely seen practically as there is always a certain amount of product differentiation which leads to there not be a single price for the product. Also, the market price may vary over very short periods of time due to external reasons such as promotions or the seasonality of the product. (APM Stuff, 2011)

Cost- based transfer pricing:

Full Cost Plus Pricing: Full cost includes the variable cost as well as the fixed cost involved in the production of the transferred product. Here the transfer price is set as the full cost plus some mark-up. This type of transfer pricing ensures a positive contribution margin for the selling division. However, the buying division may not be happy with this transfer price if it is greater than the market price of the product. Such kind of transfer pricing is suitable when there is no external market for the transferred product.

Marginal Cost Plus Pricing: Marginal costs means the sum of all variable costs. It is the incremental cost incurred by the seller to produce the good or provide the service. Here the transfer price is set as the marginal cost plus some mark-up. It does not ensure a positive contribution margin for the seller. Selling division needs to add attach sufficient margin in order to recover its fixed costs. The selling division may not like this kind of transfer pricing if as it involves the risk of not recovering the fixes costs. The buying division will accept the transfer price if it is lower than the market price. This kind of transfer pricing is suitable when the selling division has some unused capacity.

Marginal Cost Plus Opportunity Cost Plus Pricing: Opportunity cost is the loss of external sale opportunity due to selling of the product internally to the buying division. Marginal cost + Opportunity cost is the minimum transfer price that the selling division would accept. For selling division, there would be an incentive to transfer internally if a mark-up is added rather than selling it externally. Buying division will accept the transfer price only when the transfer price is lower than the market price. Such type of transfer pricing is used when there is no unused capacity at the selling division but there is still unmet market demand. (Investopedia, 2013)

Negotiated transfer pricing: This type of transfer pricing is used in case of an imperfect market. In case of an imperfect market, there are transaction costs both for selling and buying division if they want to buy or sell in the external market, there are different market prices for the product. In such cases transfer prices cannot be set at market prices as the selling or buying divisions would work inefficiently at those prices. The management has to intervene in such situations to arrive at a negotiated transfer price between the buying and the selling division. The negotiated transfer price would lie between the minimum price at which the selling division is willing to sell and the maximum price at which the buying division is willing to buy. The negotiated transfer pricing can however be time –consuming and can lead to sub-optimal decisions. It is strongly influenced by the bargaining skills of the selling and the buying division managers.

Market-based transfer price

Transfer pricing is used by the top level management of the corporations for the following purposes:

Profit Allocation: Transfer prices are used by the companies to determine the profits of its various divisions, which are further used for appraisals and other financial reports. While transfer price is the revenue for the selling division, it is the purchase cost for the buying division. Multi-entity Corporations use the synergies between various divisions to lower their costs and increase their overall profits.

Coordination: When a company is divided into divisions and divisional profit is the main determinant of performance measurement, divisional managers can make decisions keeping in mind only the profits of the divisions and not the company as a whole. This can lead to goal incongruence. Transfer prices decided by the centralized (top) management can influence the behavior of divisional managers and steer them to work for the betterment of the corporation. A higher transfer price leads to change in the production process of the buying division, leading them to a higher efficiency, as it reduces the amount bought by the buying division. A lower transfer price can lead to similar effects on the selling division. This exercise is also known as goal congruence.

Calculation and cost accounting: Transfer prices are used to determine the cost of goods produced for the buyer division and the revenues for the seller division. This is further used for external regulatory purposes or for third party purposes. Transfer prices lead to simplification of a lot of cost accounting calculations.

Tax Accounting: Transfer prices are used for optimization of taxes by the organizations and for other related payments. Companies structure their transfer prices based on such considerations. Some companies can (and do) manipulate their transfer prices using practices which are not always ethical to save tax liabilities. OECD has laid out guidelines to prevent such manipulations and applies the arm’s length principle. This principle requires the divisions to treat other divisions at an arm’s length, i.e as if the divisions were completely separate companies. They have to determine the arm’s length price, which can be difficult for cases where the product are differentiated.

Different governments have entered into agreements between taxpayers regarding settling on transfer prices. They are called advance pricing agreements or APAs. APAs are based on well research documentation prepared by the taxpaying corporations for the government. They require a lot of negotiations between the taxpayer and the designated government tax authority. These agreements are generally effective retrospectively.

Fraudulent transfer pricing is strongly dealt with by the governments and the relevant authority. Known as transfer mispricing, fraudulent transfer pricing relates to adjusting of transfer pricing by corporations to deceive tax authorities. For example, companies may have 2 subsidiaries with one in a tax haven and other in a high-tax regime. The one in tax haven will sell its product to an intermediate subsidiary at a low price resulting in low tax. While the intermediary will sell to the division in a high tax regime at artificially high prices so as to show low profits and hence low taxes. Such kind of manipulation is leading to capital flight from developing countries of Asia and Africa. (Lanewala, 2011)

Part B

Transfer pricing should not be based on total actual costs as this practice can be misused. An inefficient department can pass on its excess costs to the division which is buying its product and hence hide its inefficiencies. The division buying the product will hence have to show higher costs due to the higher price it is paying to the inefficient producing division. Similarly, an efficient producing division will have to sell its products at lower prices to the buying division, which can exploit the lower transfer costs to show higher margins. Thus, transfer prices based on total actual costs would not give a fair assessment of divisional performance.

 

Cleaning and Scraping  Division     

 Processing Division

Sale Price

95

160

Transfer Price

0

95

Direct Material

18

5

Direct Labour

12

10

Manufacturing overhead (variable)

30

10

Variable Selling Cost

5

0

Contribution margin

30

40

Following would be the price range acceptable to both divisions if negotiated transfer pricing is used and firms are allowed to buy/sell in the open market:

Upper Limit: Market price = 95

Lower Limit: Total production cost + 20% margin = Direct Material + Direct Labour + Manufacturing overhead + 20% margin = 60 +12 = $72

Therefore the price range would be $72 - $90.

As discussed in Part c, lowest transfer price acceptable to Cleaning and Scraping division would be $72. This would not be preferred by the manager of the Cleaning and Scraping division as it would mean a contribution margin of only (72-60=) $12. If it sells on the open market it would mean a contribution margin of $30. Thus the Cleaning and Scraping division will lose ((30-12)*400000=) $7,200,000 by accepting a transfer price of $72. This would not show a good performance by the Cleaning and Scraping division manager.

References:

APM Stuff, 2011, Different Types of Transfer Pricing Methods, Blogspot, viewed September 16, 2016 <https://apmstuff.blogspot.in/2011/07/different-types-of-transfer-pricing.html>

Burkadze, E., 2016, Interaction of Transfer Pricing Rules and CFC Provisions, International Transfer Pricing Journal, viewed September 16, 2016 <https://www.ibfd.org/IBFD-Products/Journal-Articles/International-Transfer-Pricing-Journal/collections/itpj/html/itpj_2016_05_int_3.html>

Chand, S., 2014, 5 Types of Transfer Pricing Methods used in International Marketing, Your Article Library, viewed September 16, 2016 <https://www.yourarticlelibrary.com/product-pricing/5-most-important-types-of-transfer-pricing-methods-used-in-international-marketing/5820/>

Investopedia, 2013, Transfer Price, Investopedia, viewed September 16, 2016 <https://www.investopedia.com/terms/t/transferprice.asp>

Lanewala, M., 2011, Types of Transfer Pricing for Measuring & Evaluating Divisions, Management Accounting, viewed September 16, 2016 <https://managementaccounting.accasupport.com/2012/08/types-of-transfer-pricing-for-measuring.html>

Schuster, P., 2010, Transfer Prices: Functions, types and behaviuoral implications, questia, viewed September 16, 2016 <https://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch11_s08

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