Transfer Pricing
Transfer pricing is often the price one division charges another division for goods or
services within the same company.
For example:
Division A makes computer chips.
Division C uses those chips to make video recorders.
Division A sells the chip to Division C at a "transfer price" (say $30).
The Impact of Transfer Pricing on Income
If the price is too high, Division A looks good (high revenue), but Division C looks worse
(high costs).
If the price is too low, Division C benefits but Division A loses revenue.
Even though it cancels out for the overall company (since one division's revenue is
another's cost), it affects:
o Each division's profits
o Managers' performance evaluations
o Return on Investment (ROI)
Methods of Setting Transfer Prices
The text discusses various methods for setting transfer prices, including:
Cost-Based Pricing: This involves setting the transfer price based on the costs incurred
by the selling division plus a markup.
Market-Based Pricing: The transfer price is set based on the price of similar goods or
services in the external market.
Negotiated Pricing: The price is determined through discussions between the divisions
involved
Objectives of Transfer Pricing
A well-structured transfer pricing system should satisfy three main objectives:
Accurate Performance Evaluation: Each division's performance should be assessed
fairly without one benefiting at the expense of the other.
Goal Congruence: The transfer pricing should motivate divisional managers to make
decisions that maximize overall company profits rather than just their division's profits.
Divisional Autonomy: Divisional managers should retain the freedom to make decisions
without excessive interference from central management
Setting Transfer Pricing
Transfer pricing refers to the prices at which divisions of a company transact with one another.
Setting an appropriate transfer price is crucial for both performance evaluation and tax
compliance. The transfer price impacts the financial results of both the selling and buying
divisions, affecting their reported profits and performance metrics.
Opportunity cost approach
The opportunity cost approach identifies the minimum and maximum prices for internal
transactions based on the potential benefits foregone by the selling and buying divisions.
Minimum Transfer Price (Opportunity Cost)
The minimum transfer price is the price at which the selling division would be indifferent
between selling internally and selling externally. This price must cover:
• The marginal cost of production (direct costs).
• The opportunity cost, which is the profit that the selling division would forego by not selling to
an external party.
Example: If Division A can sell a component externally for $15 but incurs a cost of $10 to
produce it, the minimum transfer price for Division A to sell internally to Division B should be at
least $15. This ensures Division A does not lose out on potential profits.
Market Price
The market price method sets the transfer price based on prevailing market prices for similar
goods or services. This method is often preferred as it reflects the external economic
environment and can help maintain fairness and transparency in internal transactions.
When to Use Market Price
Existence of External Market: If there is a competitive market for the goods being
transferred, the market price should be used as it reflects the true economic value of the
goods.
Performance Evaluation: Using market prices can simplify performance evaluations
since they are based on observable external benchmarks.
Example: If Division A sells a component to external customers for $20, then the transfer price
for an internal sale to Division B should also be set around $20, assuming no significant cost
savings for internal transactions.
Benefits of Using Market Price
Simplicity: It is straightforward to determine and apply.
Fairness: It ensures that both divisions are treated equitably based on external market
conditions.
Alignment with Corporate Goals: It encourages both divisions to act in the company's
best interest, as both are incentivized to maximize profitability.
Sure! Let’s break it down step by step so you clearly understand how transfer pricing works, and why it’s
important in business and taxation.
🔁 What is Transfer Pricing (Simplified)?
Transfer pricing is the price one part of a multinational company charges another part of the same
company for goods, services, or intellectual property.
These internal prices affect where the company shows profits, which in turn affects how much tax the
company pays in different countries.
🧩 Why It Matters:
Different countries have different tax rates.
Companies may set transfer prices in a way that shifts profits to low-tax countries, which lowers
their overall tax bill.
This practice can be legal if the prices are fair (arm’s length), but if manipulated, it’s considered tax
avoidance or even illegal.
👟 Example: GlobalShoes Inc.
Let’s say GlobalShoes is a shoe company with two parts:
A makes soles (manufacturing)
B assembles and sells finished shoes
✅ Scenario 1: Fair Transfer Price ($30)
A makes a sole for $10
Sells it to the B for $30
B assembles the shoe for another $20
Sells final shoe for $100
Profits:
A : $30 (revenue) – $10 (cost) = $20 profit → 15% tax = $3
B : $100 (revenue) – $30 (sole) – $20 (assembly) = $50 profit → 25% tax = $12.50
📌 Total tax paid globally = $15.50
🚩 Scenario 2: Inflated Transfer Price ($60)
Now, GlobalShoes sets the price of the sole at $60 instead of $30.
Still costs $10 to make in A
B still sells the final shoe for $100
Assembly still costs $20
Profits:
A : $60 – $10 = $50 profit → 15% tax = $7.50
B : $100 – $60 (sole) – $20 = $20 profit → 25% tax = $5
📌 Total tax paid globally = $12.50
🧮 What Changed?
Scenario Profit in A Profit in B Total Tax
Fair $20 $50 $15.50
Inflated $50 $20 $12.50
By inflating the price of the sole, GlobalShoes shifted $30 of profit from the B to the A, where taxes are
lower.
This saved the company $3 in taxes per shoe.
⚖️Is It Legal?
If $60 is a realistic market price, it's legal.
If it’s too high compared to market value, tax authorities may say it's not an "arm’s length"
transaction, and the company could face:
o Fines
o Back taxes
o Reputation damage
🧠 Why Governments Care:
Countries don’t want companies hiding profits in tax havens or low-tax countries. That’s why there are
global rules (like the OECD Transfer Pricing Guidelines) to make sure companies use fair prices for
internal transactions.
