TRANSFER PRICING
P2 CHAPTER 10
Purposes of
decentralisation
Through performance
Give autonomy to local enhancement at a profit
Motivate centre managers
centre managers in decision center level, to achieve
to improve performance
making better results for the whole
organisation
Profit managers may start looking at their own interests and take decisions that amplify their own profits
but may not be beneficial to the organisation on a whole. In such a situation, the head office might
interfere in the decision making but this hurts the local autonomy.
TRANSFER PRICING
Interdependence between various departments or profit/ investment centres in terms of
exchanging goods and services.
Profit centres want to earn income from the transfers to maintain their performance.
The price at which goods are sold internally is called transfer price.
The price causes sales income for the selling centre and purchase cost for the buying centre.
The two costs cancel each other out at the central level. Thus, profit is generated at the individual
profit centres but no effect is made on the overall profits of the company on a whole.
Rules to remember:
1. Both divisions must have some benefit from the transaction or else they will not participate in it.
2. The transfer price can be imposed by the head office, decided by commercial negotiation, decided
amongst the managers themselves.
3. For the selling division, the preference should be to sell internally and for the purchasing division,
the preference should be to buy internally.
4. However, if there is a commercial reason (availability of better prices externally) then the
managers should have the option to buy/ sell from/ to an external party.
Illustration
A company has two profit centres, Centre A and Centre B. Centre A supplies Centre B with a part-finished
product. Centre B completes the production and sells the finished units in the market at $35 per unit.
BUDGETED DATA FOR YEAR
Particulars Division A Division B
No. of units transferred 10000 10000
Material cost 8/unit 2/unit
Other variable costs 2/unit 3/unit
Annual fixed costs 60000 30000
Calculate budgeted annual profit of each profit centre and the organisation as a whole if the transfer price
for components supplied from A to B is:
$20
Solution:
Division A
Sales price 20
Total variable costs (10)
Contribution per unit 10
Total units transferred 10000
Total contribution 100000
Fixed costs (60000)
Profit 40000
Division B
Sales price 35
Total variable costs (5)
Contribution per unit 30
Total units transferred 10000
Total contribution 300000
Interdepartmental purchase (200000)
Fixed costs (30000)
Profit 70000
Company on a whole
Sales price 35
Total variable costs (15)
Contribution per unit 20
Total units transferred 10000
Total contribution 200000
Interdepartmental transfers 0
Fixed costs (90000)
Profit 110000
Objectives of transfer pricing
Recording Fair allocation
Maintaining Minimising
Goal Performance movement of of profits
divisional global tax
congruence measurement goods and between
autonomy liability
services divisions
Basis for setting transfer prices
Market based prices Cost based prices Negotiated prices
Market price of the product
Actual or budgeted
- packaging, distribution and
(preferred) total cost/
warranty costs (costs saved
marginal cost + markup
due to internal transfer)
Intermediate market for products/ services
Perfect Imperfect Non existent
In an imperfect market, pricing
All the produce can be sold in products is more difficult and
the market for existing market profit maximisation model Since there is no market for the
price. Thus market price should be used (MR = MC) product, cost model should be
approach in transfer pricing is used for transfer prices
appropriate As discussed in the pricing
decision chapter
TRANSFER PRICING GENERAL RULES
All goods and services should be transferred for opportunity cost
Possible situations
in transfer pricing
Competitive market Production
Selling division has
for intermediate constraints and no
surplus capacity
product surplus capacity
TRANSFER PRICING WITH A COMPETITIVE MARKET FOR INTERMEDIATE PRODUCT
Only one market price
No buying or selling costs
Market can absorb entire production output of primary division and meet all requirements of
secondary division
OPTIMUM TRANSFER PRICE = MARKET PRICE + ANY SMALL ADJUSTMENTS
Illustration
Division A of the Robin Group makes a product A22, which it sells externally and to another division
in the Group, Division B. Division B uses product A22 as a component in product B46, which it sells
externally. There is a perfect external market for both A22 and B46.
Sales price of product A22 in the market is $20
Now, division A won’t sell to division B if they are paying anything less than $20, since they can then
easily sell the product outside for $20.
Division B won’t buy for a price higher than $20 because they can buy it from outside at $20.
Hence optimum transfer price is the market price.
However, in the same example, if there was a variable selling cost of say $3, then the optimum
transfer price would be market price – selling cost, since they will not be incurred on internal sales.
Hence TP would be 20-3 = $17
TRANSFER PRICING WHEN SELLING DIVISION HAS SURPLUS CAPACITY
There’s a limit on the quantity that can be sold outside
There is spare capacity
Opportunity cost of transferring units internally is nil
Ideal TP would be at cost
OPTIMUM TRANSFER PRICE = MARGINAL COST
Problem here is that it is unfair for the supplying division to make no profits. Hence, there are a few
solutions.
Solution
2 part tariff Cost plus pricing Dual pricing
A markup is added to the
The transfer price is total or marginal If no common ground
marginal cost, standard cost. Actual cost can be reached, one
Additionally, a fixed sum is not used so that price is recorded by
is paid per period to the manager is motivated to selling division and
supplying division to another by purchasing
keep the costs within
cover fixed costs, and standard limit dept and the difference
generate a profit. is recorded in HQ's
books. This is not
desirable for the overall
welfare of the company
Disadvantage:
1. Doesn't provide motivation to selling division manager
to reduce costs
2. Performance measurement for selling division not fair
3. Negotiation process is time consuming
TRANSFER PRICING WITH PRODUCTION CONSTRAINTS AND NO SURPLUS CAPACITY
Shadow price is the opportunity cost of the lost contribution from the other product or it is the
extra contribution that would be earned if more of the scarce resource were available.
OPTIMUM TRANSFER PRICE = MARGINAL COST + SHADOW PRICE
Illustration
Alameda Ltd has two divisions, Division Alpha and Division Beta. Division Alpha makes widgets, which it can
sell externally for $45 as well as internally to Division Beta. The marginal cost of making a widget is $30 per
unit in Division Alpha, and the division has no spare capacity. Division Beta turns widgets into another
product, the bidget, at a marginal cost of $55 per unit. Division Beta can then sell bidgets externally for
$120 per unit. External sales of widgets incur a variable distribution cost of $3 per unit. What is the
optimum TP for widget?
Solution
Since widget can be sold outside for $45 by incurring a selling cost of $3, the optimum TP for internal
transfer should be 45-3= $42
INTERNATIONAL TRANSFER PRICING
MNCs can have cross border transfers that lead to tax implications.
MNCs try to minimise tax implications through cross-border transfers. This can be done by:
1. Reducing profits in high tax area
2. Increasing profits in low tax area
Illustration
Seacross Group has two subsidiaries, UKD in the UK and GD in Germany. UKD makes and sells Product S99.
The variable cost of manufacture in the UK is £200 per unit and annual fixed costs are £210,000. Product
S99 sells for £500 per unit in the UK market and annual demand is 800 units. GD in Germany buys 400 units
of S99 from UKD each year, adapts them for the German market, and sells them for the equivalent of £700
per unit. The variable costs of adapting the product and selling it in Germany are £50 per unit. The cost of
shipping the 400 units to Germany is £6,000 and these are paid by GD. Fixed costs in GD are £24,000 each
year. The rate of taxation on company profits is 30% in the UK and 50% in Germany. Calculate after tax
profits of the group if TP for S99 is UK market price 500
Solution
Particulars UK Germany Company
External sales 400000 280000 680000
Interdivisional transfer 200000 0 0
Total sales 600000 280000 680000
Costs
Interdivisional transfer 0 200000 0
Other variable costs 240000 20000 260000
Shipping costs 0 6000 6000
Fixed costs 210000 24000 234000
Total costs 450000 250000 500000
Pre-tax profits 150000 30000 180000
Tax (45000) – 30% (15000) – 50% (60000)
After tax profit 105000 15000 120000
GOVERNMENT ACTION ON TRANSFER PRICING
Government knows that MNCs try to minimise taxes.
Many countries require justification for transfer prices.
MNCs can be required to apply ‘arm’s length prices’ which are market based prices.
Countries that want to attract business may also have lax rules and maybe called ‘tax haven’
Tax havens are hotspots for MNCs. They may offer:
1. Low rate of tax
2. Low withholding tax on dividends paid to foreign companies
3. Tax treaties with other companies
4. No exchange control
5. Stable economy
6. Good communication systems
7. Well-developed legal framework
TRANSFER PRICING TO MANAGE CASH FLOWS
Some governments might place legal restrictions on dividend payments by companies to foreign
parent companies.
In this situation, multinationals may sell goods or services to a subsidiary in the country concerned
from other divisions in other countries, and charge very high transfer prices as a means of getting
cash out of the country.
However, if there are rules to maintain arm’s length prices, this is not possible.
INTERNATIONAL TRANSFER PRICING AND CURRENCY MANAGEMENT
When inter-divisional transfers are between subsidiaries in different countries or currency zones, a
decision has to be made about the currency to select for transfer pricing.
Exchange rates are volatile and can lead to forex profits/ losses.
Example: A UK subsidiary sells goods to a US subsidiary for $12.80 per unit. The exchange rate was
£1 = $1.60 when the transfer price was agreed, and the cost of making each unit in the UK and
shipping it to the US is £6. When the exchange rate is $1.60, the sterling equivalent value of the
$12.80 transfer price is £8, and the UK subsidiary makes a profit of £2 per unit transferred.
However, if the dollar weakened in value, and the exchange rate moved to $2.00, the sterling value
of the transfer price would fall to £6.40, and the profit per unit would fall to £0.40.
Implications
When it is fairly
certain which way an
exchange rate might
move in the future, a
multinational
Management of
When one subsidiary company might be
exposures to
makes a loss on an tempted to set
currency risks might
Exposure to forex adverse exchange transfer prices in a
be the responsibility
losses rate movement, the currency such that
of either the profit
other will make a any currency losses
centre managers or a
profit. arise in the subsidiary
treasury department.
in the high-tax
country, and currency
profits arise in the
country with the
lower tax rate.
