4/04/2014

WHAT IS TRANSFER PRICING?

TRANSFER PRICING

A mechanism to distribute revenue generated from

CHAPTER 6

Transfer price:
the amount used in accounting for any transfer of goods and
services between responsibility centers
the value placed on a transfer of goods or services in
transaction in which at least one of the two parties involved in
a profit centers

ZUNI BAROKAH, PH.D.

MAGISTER MANAJEMEN
FAKULTAS EKONOMIKA DAN BISNIS UGM
2014

the sale of products

Typically

TRANSFER PRICING METHODS:

Fundamental Principle

OBJECTIVES OF TRANSFER PRICING

Providing business units with relevant information

to determine optimum trade-off

Fundamental principle:
Transfer

price should be similar to the price if the

product were sold to outside parties

Inducing goal congruence decisions

Helping measuring the economic performance of

business units

contain profit element

Many disagreement on how outside selling

prices are established

Simple to understand, easy to administer

TRANSFER PRICING METHODS:

Fundamental Principle
Using marginal cost as selling prices is unrealistic
Decisions must be made on inter-profit-units sales:
Sourcing decision
Transfer price decision

The Ideal Situation

for a Market Price-Based Transfer Price
Conditional situation:
Competent People
Good Atmosphere
A Market Price

Using marginal cost as selling prices is unrealistic

Decisions must be made on inter-profit-units sales:
Sourcing decision
Transfer price decision

Ideal: a well established, normal market price for

identical product

Freedom To Source
Freedom to buy from and sell to the outside
Full Information
Negotiation

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Constraints On Sourcing: Limited Markets

Reasons:

Constraints On Sourcing: Limited Markets

Ways to find out the competitive price without

Internal capacity might limit the external sales development

buying from or selling to the outside market:

The company is the sole producer of the differentiated product

Using published market prices

Has the company invested significantly in facilities, usage of

Bids

Using prices of similar product that the production profit

outside sources is unlikely

center sells to outside markets as the basis

In this case, the transfer price that best satisfies

profit center system is: the competitive price

Using prices of similar product that the buying profit center

buys from outside markets as the basis

Constraints On Sourcing: Excess Or Shortage Of

Industry Capacity
Industry capacity (excess or shortage) can cause a lot

Cost Based Transfer Prices

The Cost Basis Decision

1.

Standard cost is a usual basis

of issues, relating to the company profits

The Profit Mark Up Decision

2.

Decisions:
Percentage of cost basis:

Senior managements try not to intervene, but allow

profit center to appeal a sourcing decision to a

central person or committee.

simple, widely used

Capital requirement does not count

Percentage of investment basis:

Conceptually better
Practical problem in calculating investment applicable to product

How much should the amount of profit be?

Cost Based Transfer Prices:

Upstream Fixed Costs and Profits:

Solutions

Upstream Fixed Costs and Profits

Profit centers might not be aware of the amount of

upstream fixed costs and profits in internal purchase

price
Even if they are aware, profit centers might

complex to calculate, less satisfactory than a market based price

Agreement among Business Units

1.

Value worth the effort only to decisions involving a significant

amount of business to at least on of the profit centers

2. Two-Step Pricing
A transfer price that includes 2 charges:

reluctant to reduce their own profit to optimize

company profit

Charge

equal to standard variable cost of production for each unit

sold
Periodic charge equal to the fixed costs associated with the
facilities reserved for the buying units
One or both should include a profit margin.

See Exhibit 6.2

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Upstream Fixed Costs and Profits:

Solutions
Two-Step Pricing: points to consider

Fixed costs and profits monthly charge should be negotiated

periodically, and will depend on the business units capacity
reserved
Questions about the accuracy of the costs and investment
allocation: not the allocation technique, but the amount of
capacity reserved for products
Manufacturing units profit performance is not affected by the
sales volume of the final unit
Conflict of interest between manufacturing units and company
may arise
Similar to take or pay pricing, frequently used by long term
contracts company

Upstream Fixed Costs and Profits:

Solutions
4. Two Sets of Prices
Manufacturing units revenue is credited at the outside sales
price;
The buying units is charged the total standard costs;
Differences charged to HQ account and eliminated when the
business unit statements are consolidated
Disadvantages:
The

sum of business unit profits > overall company profits

feeling that business units are making profits
are motivated to concentrate more on internal sales
There is additional bookkeeping
Lessened conflicts between unit business
Illusive

Business units

Control over Amount of Service

In-sourcing vs out-sourcing decision
What if business units are required to use company

Upstream Fixed Costs and Profits:

Solutions
3. Profit Sharing
a.
Products transferred to marketing units at standard price
b. After the products is sold, the business units share the
contribution earned (price variable manufacturing costs
marketing costs)
Might used to ensure congruence between business unit and
company interest
Practical problems:
How

will the contribution be divided? Senior management might

have to intervene
By using this, there is no valid information on the profitability of
each unit

PRICING CORPORATE SERVICES

Charging business units for services furnished by

corporate staff units

Charged by allocating, the allocations do not include

a profit component and are not transfer prices.

Types of transfers:
Central services that receiving unit must accept, but can
partially control the amount used
Central services that receiving unit can decide whether or not
to use

Optional Use of Services

B.U. has the authority to decide whether to use

central service unit, develop their own capability,

outsource it, or not to use service at all.

resources for services (e.g., IT or R&D)?

In-sourcing: BU manager cannot control efficiency but can control

the amount of service received
Three schools of thought:
1.
2.
3.

B.U. pay the standard variable costs of the discretionary services

B.U. pay the full costs (standard variable costs + fair share of
standard fixed costs)
B.U. pay the market price (standard full costs + profit margin)
e.g., full cost + ROI

B.U. managers control both the amount and the

efficiency -> transfer prices should be based on the

same considerations as the usual transfer prices

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Simplicity of the Price Mechanism

The methods of calculating the service prices should

be straightforward enough

Administration of Transfer Prices

How should the selected policy of transfer pricing be

implemented?

Negotiation
Arbitration and conflict resolution
Product classification

Negotiation
In some cases, headquarters staff needs to develop a set of
rules that govern both pricing and sourcing of intracompany
products
The rules have to be specific to avoid time delay

Administration of Transfer Prices

Arbitration and conflict resolution

What if business units can not agree on a price?

the company may choose a single executive or form a committee to:
Settling transfer price disputes
Reviewing sourcing changes
Changing the transfer price rules when appropriate

Administration of Transfer Prices

Product classification
The greater the number of transfers and the availability of
market prices, the more formal and specific the rules

B.U. submits a written case (in formal system) or oral presentation

(in less formal system)
Type of conflict resolution process:
Forcing
Smoothing
Bargaining
Problem solving

Some companies divide products to:

Class

1 : all products for which senior management wishes to

control
sourcing can only be changed by permission of central
management
Class 2 : all other products
determined by the business units involved