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Transfer pricing

This document discusses transfer pricing, which refers to the price charged between divisions of the same organization for goods or services. The objectives of transfer pricing include evaluating divisional performance and profitability, improving profits, ensuring optimal resource allocation, and providing information to management. Common transfer pricing methods are total cost, marginal cost, standard cost, market price, and negotiated price. Each method has advantages and disadvantages related to divisional incentives, profit measurement, and treatment of fixed and variable costs. Transfer pricing aims to balance divisional autonomy with overall organizational goals but can also cause conflicts between divisions.

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TRANSFER PRICING RATHI K N Assistant Professor Sreekrishnapuram V T Bhattathiripad College Mannampatta,Palakkad Kerala
Transfer pricing  This is the price that one division, department or section charges for a product or service supplied to another department.  According to Horngreen “ the amount charged by one segment of an organization of product of service to the segment producing the product (service) and it is the cost to the acquiring segment”
Objectives of Transfer pricing  To evaluate performance and profitability of each individual division  To improve the profit position.  To ensure congruence  To ensure divisional autonomy  To ensure optimal allocation of resources  To provide relevant information to top level management  To take good look to international trade  Others – Reduce the customs duty in the transfer of products to different departments of the same organization - Helps the firms to import the items with out restrictions
Methods of transfer pricing  Total cost method  Total cost plus profit margin method  Marginal cost method  Standard cost method  Opportunity cost method  Market price method  Negotiated price method  Arm’s length method  Dual price method
Total cost method and Total cost plus profit margin method  Total cost method – Transfers the goods at a price equal to the total of fixed and variable cost per unit. ie. Total cost.  Total cost plus margin method – transfers the goods at a price equal to the total cost plus a fixed percentage of profit.
Advantages and disadvantages of Total cost method  Advantage:  Tax authorities prefers this method  Simple and easy to understand  Disadvantages:  Fixed cost is irrelevant in transfer pricing  As a profit centre the selling division lack its earnings  No any incentive to selling division  Inclusion of Selling and distribution expenses is not clear.
Advantages and disadvantages of Total cost plus profit margin method Advantage:  Profit performance of each unit is measurable in this method  Simple and easy to understand  Helps in comparison of return on investment of different profit centres  There is an incentive to selling division  Disadvantages:  The added profit is irrelevant and leads to unnecessary adding of asset of the firm  There is a chance of Audit objection  Difficult to determine the profit  Inclusion of profit margin is not clear sometimes and thus purchase department may object.
Marginal cost method, Standard cost method and Opportunity cost method  Marginal cost method – Transfers the goods at a price equal to the total of variable cost per unit. ie. Marginal cost.  Standard cost method – Transfers the goods at standard cost which is decided in advance by the management  Opportunity cost method – Goods and services are transferred by the selling division at opportunity cost. This method
Advantages and disadvantages of Marginal cost method  Advantage:  This method encourages the buying department to acquire goods internally  Simple and easy to understand  This method is desirable when the selling division has an idle or unused capacity  Disadvantages:  As a profit centre the selling division lack its earnings  No incentive to selling division to recover fixed cost  Difficult in valuation of Work In Progress and Finished goods
Advantages and disadvantages of Standard cost method  Advantage: This method provides incentive to selling division Simple when standards are properly set The selling division can not impose its cost of inefficient operation to buying division  Disadvantages:  The selling division loses its identity as a profit centre  It is required to provide incentive to managers to improve standards  Difficult to set standard cost
Market price method and Negotiated price method  Market price method – this method is using the current market price by the selling division for internal transfers  Negotiated price method – both buying and selling department negotiates the price and they arrive with a mutually agreed price
Advantages and disadvantages of Market price method  Advantage:  This method facilitates comparing the divisions’ profitability with similar organisations  Appropriate method in a competitive environment  It preserves the selling division’s autonomy  There is an incentive to selling division  Disadvantages:  It is not suitable for the divisions with specialized products which are not substitute available  Market price for an intermediate product is not available  It is difficult to decide the market price where different suppliers quotes different price  Market price fluctuates from time to time
Advantages and disadvantages of Negotiated price method  Advantage: It facilitates achieving overall organizational objectives It helps in reducing undesirable consequences between divisional managers  Disadvantages:  It is time consuming  Negotiated price is depending upon the negotiating skill of managers
Arm’s length method and Dual price method  Arm’s length method – it is the price that would be charged or would have been charged for the same product or services with different parties under similar conditions  Dual price method – there are two transfer prices here; buying division charged with variable cost and selling division charged with total cost.
Benefits of transfer pricing  It helps in Evaluating departments  It helps in improving inter divisional competitive spirit  Management by exemption is possible  It helps in assessing the suppliers price  It helps in Policy making  It helps in achieving organisational goal
Problems in transfer pricing  Possibility of conflict  Additional Time and effort  Issues in MNC set up  All methods have their own limitations
Thank You Rathi K N