Transfer Pricing

Transfer pricing is a key element of divisional performance management.

 The transfer price is the price at which good or services are transferred from one division to another within the same organisation.

Characteristics of a good transfer price

• Goal congruence - the transfer price that is negotiated and agreed upon by the buying and selling divisions should be in the best interests of the company overall.
• Fairness - the divisions must perceive the transfer price to be fair since the transfer price set will impact divisional profit and hence performance evaluation.
• Autonomy - the system used to set the transfer price should seek to maintain the autonomy of the divisional managers. This autonomy will improve managerial motivation.
• Bookkeeping - the transfer price chosen should make it straightforward to record the movement of goods or services between divisions.
• Minimise global tax liability - multinational companies can use their transfer pricing policies to move profits around the world and thereby minimise their global tax liability.

The general rules for setting transfer prices

Scenario 1: There is a perfectly competitive market for the product/service transferred

Transfer price = market price

A perfect market means that there is only one price in the market, there are no buying and selling costs and the market is able to absorb the entire output of the primary division and meet all the requirements of the secondary division.

Scenario 2: the selling division has surplus capacity

Scenario 3: The selling division does not have any surplus capacity

Practical methods of transfer pricing

Method 1: Market based approach

If a perfectly competitive market exists for the product, then the market price is the best transfer price.

• Care must be taken to ensure the division's product is the same as that offered by the market (e.g. quality, delivery terms, etc.).
• The market price should be adjusted for costs not incurred on an internal transfer, e.g. delivery costs.

Method 2: Cost based approach

Alternatively, if a perfectly competitive market does not exist for the product, the transfer price can be set at cost + % profit.

• Standard cost should be used rather than actual cost to avoid inefficiencies being transferred from one department to another and to aid planning and budgeting.
• The cost may be:
  • the marginal cost - this will be preferred by the buying division, i.e. they will consider the price to be fair.
  • the full cost - this will be preferred by the selling division, i.e. they will consider the price to be fair.
  • the opportunity cost - if there is no spare capacity in the selling division the opportunity cost should be added to the marginal cost/full cost.
• 'Fairness' is one of the key characteristics of a good transfer price. Two alternative approaches that may be perceived as fair by both the buying and the selling divisions are:
  • marginal cost plus a lump sum (two part tariff) - the selling division transfers each unit at marginal cost and a periodic lump sum charge is made to cover fixed costs.
  • dual pricing - the selling division records one transfer price (e.g. full cost + % profit) and the buying division records another transfer price (e.g. marginal cost). This will be perceived as fair but will result in the need for period-end adjustments in the accounts.

 Illustration - Practical methods of transfer pricing

Manuco Ltd

Manuco Ltd has been offered supplies of special ingredient Z at a transfer price of $15 per kg by Helpco Ltd, which is part of the same group of companies. Helpco Ltd processes and sells special ingredient Z to customers external to the group at $15 per kg. Helpco Ltd bases its transfer price on total cost-plus 25% profit mark-up. Total cost has been estimated as 75% variable and 25% fixed.

Required:

Discuss the transfer prices at which Helpco Ltd should offer to transfer special ingredient Z to Manuco Ltd in order that group profit maximising decisions may be taken on financial grounds in each of the following situations.

(a)Helpco Ltd has an external market for all its production of special ingredient Z at a selling price of $15 per kg.Internal transfers to Manuco Ltd would enable $1.50 per kg of variable packing cost to be avoided.

(b)Conditions are as per (i) but Helpco Ltd has production capacity for 3,000kg of special ingredient Z for which no external market is available.

(c)Conditions are as per (ii) but Helpco Ltd has an alternative use for some of its spare production capacity. This alternative use is equivalent to 2,000kg of special ingredient Z and would earn a contribution of $6,000.

Solution

(a)Since Helpco Ltd has an external market,which is the opportunity foregone, the relevant transfer price would be the external selling price of $15 per kg. This will be adjusted to allow for the $1.50 per kg avoided on internal transfers due to packing costs not required, i.e. the transfer price is $13.50 per kg.

(b)In this situation Helpco has no alternative opportunity for 3,000kg of its special ingredient Z. It should,therefore, offer to transfer this quantity at marginal cost. This is variable cost less packing costs avoided = $9 – $1.50 = $7.50 per kg(note: total cost = $15 x 80% = $12; variable cost = $12 x 75% =$9). The remaining amount of special ingredient Z should be offered to Manuco Ltd at the adjusted selling price of $13.50 per kg (as above).

(c)Helpco Ltd has an alternative use for some of its production capacity, which will yield a contribution equivalent to $3 per kg of special ingredient Z ($6,000/2,000kg). The balance of its spare capacity (1,000kg) has no opportunity cost and should still be offered at marginal cost. Helpco Ltd should offer to transfer: 2,000kg at $7.50 + $3 = $10.50 per kg; 1,000kg at $7.50 per kg (= marginal cost);and the balance of requirements at $13.50 per kg.

International transfer pricing

Almost two thirds of world trade takes place within multi-national companies. Transfer pricing in multi-national companies has the following complications:

Taxation

The selling and buying divisions will be based in different countries. Different taxation rates in these countries allows the manipulation of profit through the use of transfer pricing.

 Illustration - Taxation and transfer pricing

Rosca Coffee is a multinational company. Division A is based in Northland, a country with a tax rate of 50%. This division transfers goods to division B at a cost of $50,000 per annum. Division B is based in Southland, a country with a tax rate of 20%. Based on the current transfer price of $50,000 the profit of the divisions and of the company is as follows:

Rosca Coffee want to take advantage of the different tax rates in Northland and Southland and have decided to reduce the transfer price from $50,000 to $20,000. This will result if the following revised profit figures:

Conclusion: the manipulation of the transfer price has increased the company's profits from $64,000 to $73,000.

• Artificial attempts at reducing tax liabilities could, however, upset a country's tax authorities. Many tax authorities have the power to alter the transfer price and can treat the transactions as having taken place at a fair arms length price and revise profits accordingly.

Remittance controls

• A country's government may impose restrictions on the transfer of profits from domestic subsidiaries to foreign multinationals.
• This is known as a 'block on the remittances of dividends' i.e. it limits the payment of dividends to the parent company's shareholders.
• It is often done through the imposition of strict exchange controls.

 Additional example on international issues

A multinational organisation, C plc, has 2 divisions each in a different country - Divisions A and B. Suppose Division A produces a product X where the domestic income tax rate is 40% and transfers it to Division B, which operates in a country with a 50% rate of income tax.An import duty equal to 25% of the price of product X is also assessed.The full cost per unit is $190, the variable cost $60.

Required:
The tax authorities allow either variable or full cost transfer prices. Determine which should be chosen.

Solution

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Tags:	transfer pricing;divisional performance management;divisional PM