Transfer Pricing

Transfer Pricing:- a Transfer pricing is the internal price charged by a selling department, division or subsidiary of a company for a raw material , component or finished goods or services which is supplied to a buying department, division or subsidiary of the same company. The concept of transfer price is fundamentally aimed at simulating external market conditions within the organization so that the managers of individual business unit are motivated to perform well. It does not have any direct accounting impact on the organizations profit as a whole because its effect on the selling divisions revenue is matched by its effect on the buying divisions cost . However when the profits of the selling and buying division are taxed at different rates, there is some impact on the organizations profits as a whole. Transfer pricing mechanism work in different ways, if all the divisions are completely independent of each other, then the selling division will sell its product to the buying division only at the market price. Objectives of Transfer Pricing Policy:According to Robert Anthony and Vijay Govindarajan, the fundamental principle transfer pricing is that the transfer price should be similar to the price that would be charged if the product were sold to outside customers or purchased from outside vendor. The main objective of transfer pricing is the proper distribution of revenues and costs between responsibility centers . If two or more profit centers are jointly responsible for developing and marketing the product then the resulting profit has to be shared between them.

Broadly there are three objectives of transfer pricing:-

Objective of Transfer Pricing Goal Congruence

1.

Performance Appraisal

Division Autonomy

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3.

Goal congruence:-while designing the mechanism for transfer pricing , the interest of individual profit centers should not supersede those of the organization as a whole. The division manager in maximizing the profits of his/her division should not engage in decision making that fails to optimize the organizations performance. Performance appraisal:- transfer pricing should aid in reliable and objective assessment of the activities of profit centers. Transfer prices should provide relevant information to guide decision making , assess the performance of divisional manager and also assess the value added by profit center toward the organization as a whole. Divisional autonomy:-the transfer pricing should aimed at providing optimum divisional autonomy , thereby allowing the benefits of decentralization to be retained . Each divisional manager should be free to satisfy the requirements of his/ her profit center form internal or external sources. There should be no interference in the process by which the buying center manager rationally strives to minimize the costs and the selling center manager strives to maximize revenues.

In reality , it is difficult to simultaneously meet all these objectives. for example:- there may be the situation of excess capacity in the industry . It would not be prudent for the selling profit center to sell to the external market when there is excess industry capacity . However due to this excess industry capacity the buying profit center would want to buy from external market to reduce its costs rather than procure the resources available within the organization . As a result if divisional autonomy is to be retained and transfer prices are considered for performance appraisal the objective of goal congruence may not be achieved. For the organization operating in many countries , internal transfer pricing can be a determinant of where profits are to be declared and taxes paid. The fact that the different countries have different tax and exchange rates has to be taken into consideration in case of transactions with sister concerns that supply intermediary products. The transfer pricing should enable multinational corporations to minimize tax liability . Transfer pricing objectives in International Business:Apart from the objectives of the transfer pricing policy between responsibility centers in domestic operations, multinational corporations must take into consideration several other factors for arriving at their transfer pricing policy that is applicable between the legal entities in different countries.

Some of these factors are:1. Manage exchange rate fluctuation 2. Handle competitive pressure 3. Reduce impact of taxes and tariffs 4. Movement of funds between countries 1. Manage exchange rate fluctuation:- multinational corporation can reduce exchange rate risk by transfer pricing . When the currency depreciates , the purchasing power of the currency declined. Therefore ,organization based in that country may have to pay more of imports . On the contrary , if the currency appreciates , the revenues from exports will fall for organizations based in that country. But multinational corporation can depend on their subsidiaries for import and exports and use transfer prices to manage exchange rate fluctuations. e.g. they can import products at their fixed transfer prices and not at the higher prices due to depreciation of the local currency. 2. Handle competitive pressures:- the subsidiaries of an organization operating in different countries can use transfer pricing to lower prices to match local competition. e.g. garment manufactures in Europe depend mainly on China , Japan and India for silk . Therefore , if an organization has subsidiaries in these countries , it may manage to get silk at a lower cost by transfer pricing . Thus, it will be able to reduce the price of the finished products to match or undercut local competition.

3.

Reduce the impact of taxes and tariffs :-many multinational corporations make use of transfer pricing to reduce their total tax liability. Organization try to maximize profits in countries where corporate taxes are lower thus reducing the tax liability of tariffs on imports through transfer pricing when purchasing products from the overseas business units of the organization. e.g. the exporting business units can quote a lower selling prices. This will result in lower tariffs for the importing business unit, since most duties are levied on the value of the goods imported. 4. Movement of funds between countries:- a multinational corporation may prefer to invest its funds in one country rather than another . Transfer pricing providing an indirect way of shifting funds into or out of a particular country.

Method of calculating transfer prices:1. Market-based pricing method:- organization that uses this method price the goods and services they transfer between their profit centers at a level equal to the prevailing open market price for those goods and services. Advantage of market based pricing method: The division can operate as independent profit centers with the managers of these units being completely responsible for performance of their business units. This increases their motivation Makes it easy for the top management to assess the performance of the individual divisions. Tax and custom authorities favor market price method as it is transparent and they can cross-check the price details provided by the organization by comparing them with market prices on that date.

Problems with market based pricing method: There is no competitive market which can provide comparable price. There is variation in the prices between one market and another due to difference in exchange rates, transportation cost, local taxes and tariffs etc.

2.

Negotiated pricing method:In this method of transfer pricing , the buying and selling division negotiate a mutually acceptable transfer prices. Since each division is responsible for its own performance, this will encourage cost minimization and encourage the parties to seek a transfer price that yields them an appropriate return. Tax authorities have reservation about this method because it gives organization greater scope to manipulate the transfer prices and thus minimize their tax liability. Cost plus method:It is the simplest method of transfer pricing is to use full historical cost. The full cost of product is material , labor and overhead cost required to produce and ship the product to the buying unit. Full costs are the most economical transfer prices to develop because they are routinely prepared for inventory evaluation. However if the goods are transferred at cost then the selling division is only a cost center, or profit center budgeted at zero profitability if standard costs are used as the transfer prices. Some firms have attempted to use simple cost based transfer prices yet provide for profit by adding a normal markup to cost. This method produce artificial profit system which is dictated by corporate policy on markups rather than by market forces.

3.

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Marginal cost:the marginal cost of a unit is the additional cost required to produce it. If the transfer pricing system is designed to ensure efficient allocation of resources than the best transfer price to use is marginal cost. Decision making based on incremental cost determines the benefits of the decision for the organization as a whole. At less than full capacity, marginal cost consist of the variable costs of producing and shipping goods plus any cost directly associated with the transfer. At full capacity , however incremental cost must reflect the opportunity lost by foregoing sales to outside customers. In this situation, incremental cost is equal to market prices.

Significance of Transfer pricing Transfer pricing serves the following purposes. When product is transferred between profit centers or investment centers within a decentralized firm, transfer prices are necessary to calculate divisional profits, which then affect divisional performance evaluation. When divisional managers have the authority to decide whether to buy or sell internally or on the external market, the transfer price can determine whether managers incentives align with the incentives of the overall company and its owners. The objective is to achieve goal congruence, in which divisional managers will want to transfer product when doing so maximizes consolidated corporate profits, and at least one manager will refuse the transfer when transferring product is not the profit-maximizing strategy for the company. When multinational firms transfer product across international borders, transfer prices are relevant in the calculation of income taxes, and are sometimes relevant in connection with other international trade and regulatory issues.

Factors affecting transfer pricing With the government across the world tightening taxation regulations for import-exports and foreign exchange remittance , many organization are setting up specialized in house transfer pricing departments rather than leaving the function to taxation or accounts departments. Some of the conditions which are necessary for the development of a proper transfer pricing mechanism are: Role definition External advisor Competent manager Equity Information on prevailing market prices Proper investment. Role definition:- the role and scope of the team responsible for transfer pricing should be clearly defined. There should not be any confusion about the functions of the transfer team. There should be clear demarcation of activities between the transfer pricing team and the accounts and taxation teams and a document setting out each teams responsibility should be circulated to all those involved. This also ensure that all the necessary tasks are allocated.

2.

External advisor:- when necessary the organization must be ready to appoint external adviser whose knowledge and experience will be valuable to the transfer pricing team and who can provide resources not available in house. He will help the organization to see the bigger picture, which in house team may not be able to do. Competent managers:- organization need mangers who can balance long term and short term goals . Managers are often accused of sacrificing the long-term gains for short-term profits. This approach can prove to be disastrous for the organization. Transfer pricing can be misused for manipulating profits and this gives a wrong picture of the organizations position. Hence the organization should have competent people skilled at negotiation and arbitration, who are capable of determining the appropriate transfer prices such that long term goals are not sacrificed for shot term gains. There must be a mechanism for negotiating contracts and the managers who take transfer pricing decisions should be trained in art of negotiation.

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4.

Equity:- in order to achieve goal congruency, mangers of profit centers , especially the buying profit centers, should ensure that the transfer prices charged by the selling profit centers are fair. This will create atmosphere of trust between the sister concerns . The managers of the selling profit centers should be give the freedom to sell their goods in the external market , while mangers of the buying profit centers should have the option of buying their goods from the external market. The market will thus become the main determinant of the transfer price.

5.

Information on prevailing market prices:-when the product is transferred from one profit center to another, the normal market price for an identical product can be taken as basis for establishing the transfer price. While taken the market price of identical product as a reference , the quality and quantity of the reference product should be identical to those of product whose transfer price is to be fixed. Demand and supply in the market during the time of delivery should also be considered. As the product is sold within the organization , the expenses on advertising and marketing are lower and the market price can be adjusted to reflect the saving that accrue due to these lower expenses. Manger should be fully aware of market conditions and should have all t he necessary information regarding available options and the cost and revenues of each , before they take any decision on whether to purchase from outside suppliers or to resort to in-house sources. 6. Proper investment:- the transfer pricing department must be well funded and should coordinate well with other departments in the same organization, the transfer pricing departments of other business units as well as the top management. It is very important for the enterprise to comply with transfer pricing jurisdiction and to maintain documentation of transfer pricing in order to deal satisfactorily with any legal issues that may arise.

Constraints while determining the transfer price:-

External constraints 1. 2. Limited market Excess or shortage of industry capacity

Internal constraints

External constraints :- these are the constraints which are imposed by the external environment .like government regulations, climate conditions and those which cannot be controlled by the organization are called external constraints. Some of these constraints are :1. Limited market:-the market for buying and selling the goods of the profit center may be either very small or even nonexistent. in case of MNCs , if intra organizational trade take place between the divisions or subsidiaries in different countries, the interest of the organization may be in conflict with the interests of one or more of the countries. In such cases also the options for the organization to source internally become limited. Eg. Consider an organization in US that wants to buy an intermediate product from its sister concern in UK at a transfer price that is much lower than the market

Price . This transaction will record a very low or even zero profit for the organization in the UK and thus will reduce its tax liability. Therefore the UK government might not allow this transactions below market price. In such as case , the organization in the US will have no option but to pay a price closer to the market price. 2. Excess or shortage of industry capacity:- there may be a situation of excess capacity or shortage of capacity in the industry in which an organization operates. In such a situation the business unit may not consider all opportunities available to them. An example of this situation is when there is a shortage in the industry and the buying center is not able to procure form outside because the price in the market is high whereas the selling profit center is selling in the outside market. The reverse is the situation occurs when there is excess capacity in the industry. The buying profit center may purchase form outside vendors even though there is capacity available within the organization. When there is an excess or shortage of industrial capacity , the sourcing decisions taken by the organization are of critical importance. An organization may allow its buying profit center to buy goods from outside if it is getting better deal

In terms of quality, price and service. Similarly a selling profit center may be allowed to sell its products in the open market if it gets a higher profit by doing so. Otherwise the organization may appoint a central body to arbitrate on such issues. Whatever be the case the management should try to take decisions that optimize the profits of the organization. 2. Internal constraints:-the constraints imposed and controlled by the organization itself are called internal constraints. An internal constraints may arise when the existence of excess internal capacity forces the buying division not to purchase from outside sources. Another situation where an organization makes a significant investment facilities , then it will not buy the goods from outside sources even though the outside capacity exist.

Because of these constraints , it is very difficult to implement a perfect transfer mechanism in an organization. So management should be forced to set a cost based price, which is acceptable to both the selling and buying centers as a transfer price.