TRANSFER PRICING

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MANAGEMENT CONTROL SYSTEMSMBAG-307
SRI SATHYA SAI INSTITUTE OF HIGHER LEARNING

• SUBMITTED BY Regd.No16641
• SUBMITTED TOProf.Ch.RadhaKumari

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• TOPICS DISCUSSED
• INTRODUCTION
• OBJECTIVES
• PRINCIPLES AND TYPES
• METHODS
• ADMINISTRATION OF TP
• SUMMARY

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TRANSFER PRICING

• MEANING

• setting of the price for goods and services sold
  between controlled (or related) legal entities
  within an enterprise.
• For example, if a subsidiary company sells goods
  to a parent company, the cost of those goods paid
  by the parent to the subsidiary is the transfer
  price.
• Transfer pricing results in the setting of prices
  among profit centres within an enterprise.
•  Transfer pricing can be used as a profit
  allocation method to attribute a multinational
  corporation's net profit (or loss) before tax to
  countries where it does business.

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OBJECTIVES

• The transfer price should be so designed to
  accomplish the following objectives

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PRINCIPLES AND TYPES

• Fundamental principle-
• Two important made by
  Profit centers
• Sourcing decision
• Transfer price decision
• MARKET PRICE BASED-TP
• (induces goal congruence) if all of the said
  conditions exist

Transfer price should be similar to the price
that would be charged if the product were sold to
outside customers or purchased from outside
vendors.

• Market-based transfer pricing is more commonly
  used, as it offers following advantages
• mainly easy and easily understood methods.
• minimize the complications for performance
  evaluation.
• reduce points of disagreement flanked by several
  divisions.
• are usually constant with the environment
  outside.

• CONSTRAINTS OF SOURCING DECISIONS
• Limited market.
• Excess/shortage of industry capacity.

1.Freedom to source. 2.Full information. 3.Negotia
tion. 4. Good Atmosphere. 5. Competent
People. 6. Market Price.
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MARKET PRICE BASED
Freedom to source Alternatives for sourcing
should exist, and managers should be permitted to
choose the alternative that is in their best
interest.
Good Atmosphere Managers must regard
profitability as an important goal and a
significant consideration in the judgment of
their performance. Perceive that transfer prices
are just
Market Price  Transfer price is based on a
well-established normal market price for the
identical product being transferred a market
price reflecting the same conditions (quantity,
delivery time, and quality) as the product to
which the transfer price applies.
Full information Managers must know about the
available alternatives and the relevant costs and
revenues of each
Competent People Managers should be interested
in long-run as well as short-run performance of
responsibility centre.  Staff must want long-term
as well.
Negotiation Smoothly working mechanism for
negotiating "contracts" between business units.
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COST BASED TPSet on the basis of costprofit

• Cost BasisBased on standard costs Actual costs
  are not used (Production inefficiencies passed on
  to profit centre)
• Profit Mark-up

Z
Level of profit allowed
Y
3rd Party
X
Uncontrolled transaction Internal Cost-Plus
Method
Controlled transaction Transfer Price
of cost method
of investment method
3rd Party
3rd Party
Uncontrolled transaction External Cost-Plus
Method
Mechanics Of Cost Based TP
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UPSTREAM FIXED COSTS AND PROFITS

• transfer price can create problems in integrated
  companies
• profit centre that sells to outside customers may
  not be aware of the amount of upstream fixed
  costs and profits included in its internal
  purchase price
• even if profit centre was aware of costs, it
  might be reluctant to reduce its own profits

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THE PROFIT MARKUP
Two Step Pricing Example

• The simple and most widely used base is
  percentage of costs.
• (The amount of profit earned should not be high
  than the rate of return the independent business
  unit can earn if it sells the product outside.)

BUSINESS UNIT X PRODUCT A
Expected monthly sales to Business unit Y 5000 Units
Variable cost/unit 5
Monthly FC assigned to product 20000
Investment in working capital and facilities 1200,000
Return on Investment 10
Another way to transfer Pdt. A to Business unit Y is TWO STEP PRICING Another way to transfer Pdt. A to Business unit Y is TWO STEP PRICING
Particulars Transfer price for Product A
Variable cost/unit (5000units5/unit) 25000
Fixed Cost 20000
Profit 10000
TRANSFER PRICE 55000
One way to transfer Pdt. A to business unit Y is _at_ PRICE/UNIT One way to transfer Pdt. A to business unit Y is _at_ PRICE/UNIT
Particulars Transfer price for Product A
Variable cost /unit 5
Fixed cost/unit 4
Profit/unit 2
TRANSFER PRICE/UNIT 11
UPSTREAM FIXED COSTS AND PROFITS

• Agreement among business units some companies
  establish a formal mechanism whereby
  representatives from selling and buying
  department meet periodically to decide on outside
  selling prices and the sharing of profits.
• Two step pricing first, for each unit sold, a
  charge is made that is equal to the standard
  variable cost of production. And second, a
  periodic charge is made that is equal to the
  fixed costs associated with the facilities
  reserved for the buying unit.
• Profit Sharing if the two step pricing system
  is not feasible, a profit sharing system can be
  used to ensure the congruence between a business
  unit and a company.
• This system can operate as follows
• the product is transferred to the marketing unit
  at standard variable cost.
• After the product is sold, the business units
  share the contribution earned, which is the
  selling price minus the variable manufacturing
  and marketing costs.

One way to transfer Pdt. A to business unit Y is _at_ PRICE/UNIT One way to transfer Pdt. A to business unit Y is _at_ PRICE/UNIT
Particulars Transfer price for Product A
Variable cost /unit 5
Fixed cost/unit 4
Profit/unit 2
TRANSFER PRICE/UNIT 11
Conversely Y will pay less if the number of units
are more than 5000,since there are savings from
incurring additional FC

• This is the same amount Y would pay X, if the TP
  were 11/unit i.e.(5000units11 55000
• However if the transfers in another month were
  4000units, Y would pay
• 50000 (4000units5) 30000 in TWO STEP
  PRICING method,
• Compared to 44000 it would pay if the TP were
  11/unit.

The difference is due



to IDLE
CAPACITY utilization by X
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PRICING CORPORATE SERVICES

• describe problem with charging business units for
  services furnished by corporate staff units.
• exclude cost of central service staff units over
  which business units have no control

• Control over amount of services
• Business units may be required to use company
  staffs for services such as information
  technology and RD
• Business unit manager can't control efficiency
  with which these activities are performed but can
  control amount of services received.

• Simplicity of the price mechanism
• prices charged for corporate services will not
  accomplish their intended result unless the
  methods of calculating them are straightforward
  enough for business unit managers to understand
  them.

• Optional Use of Services
• management may decide that business units can
  choose whether to use central service units.
• Business units may procure services from the
  outside, develop their own capabilities, or
  choose not to use the service at all.
• often found with activities such as information
  technology, internal consulting groups, and
  maintenance work.
• business unit managers control both the amount
  and efficiency of central services.

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ADMINISTERING

• Negotiation
• Business units negotiate transfer prices with
  each other
• Establishing selling prices is one of the primary
  functions of line management
• Many transfer prices require a degree of
  subjective judgment
• Business units should negotiate prices because
  they have the best information on markets and
  costs
• Business units know ground rules within transfer
  price negotiations should be conducted

• Product Classification
• Extent and formality of sourcing and transfer
  pricing rules depend to a large extent on the
  number of intracompany transfers and the
  availability of markets and market prices
• Greater are the number of intracompany transfers
  and availability of market prices, more formal
  and specific  the rules
• Companies divide products into two main classes
• Class I all products for
  which senior management wishes to
  control sourcing (large-volume products)
• Class II all other products
  (produced outside the company)

• Sourcing of Class I and II products
• sourcing of class I products can be changed only
  by permission of central management
• sourcing of class II products is determined by
  the business unit involved.
• Both buying and selling units are free to deal
  either inside or outside the company

• Arbitration and Conflict Resolution
• There may be instances where business units won't
  be able to agree on a price
• Procedure should be put in place to arbitrate
  transfer price disputes
• One extreme is to have executives arbitrate
  dispute
• Other extreme is committee

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SUMMARY

• Delegating authority depends on the ability to
  delegate responsibility of profits.
• Where segments of a company share responsibility
  for product development,
• a TRANSFER PRICE system is required
• (if the segments are to be delegated profit
  responsibility)
• Thus transfer pricing acts as a system safeguard
  by
• accounting for the transfer of goods and
  services
• from one profit centre to another in
• companies that have a significant
• number of such transactions

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