Transfer Pricing

Govind S. Iyer

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Decentralization and Transfer Pricing

Organizations are typically divided into responsibility centers. These responsibility centers very often transfer products or services among themselves. Given that every responsibility center is a miniorganization itself, its primary objective is either the minimization of center-specific costs or the maximization of center-specific profits.

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Decentralization and Transfer Pricing

This leads to conflicts between responsibility centers which exchange products or services among themselves. Companies which are highly decentralized and which have inter-dependent divisions have to pay a lot of attention to transfer pricing. This is because sourcing and selling decisions taken by independent responsibility centers need to be optimal from the company's perspective.

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Transfer Pricing
Transfer price is the price one segment charges, for a product or service supplied to, another segment. The primary purpose of transfer pricing is to motivate managers to act in congruence with the objectives of the firm as a whole.

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Transfer Pricing
Three major decisions must be made in any transfer price situation
Sourcing: Should segments be free to decide whether to sell/buy from other segments? Transfer price: What price should be set for any transfer? Intervention Policy: When should HQ mediate to resolve disputes between divisions?

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Criteria Used to Evaluate Different Transfer Pricing Methods

Goal congruence. Inducement for optimal managerial effort in both buying and selling divisions. Promotion of sub-unit autonomy.

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Alternative Transfer-Pricing Methods

Market-based transfer prices Cost-based transfer prices
Full cost-based Variable cost-based

Negotiated transfer prices

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General Guidelines for Transfer-Pricing Based on Opportunity Costs

Seller should not settle for anything below out of pocket costs plus opportunity costs Buyer should not pay anything more than incremental value from transfer minus opportunity costs Seller and Buyer are free to negotiate as long as they follow the above guidelines Company will randomly audit transactions to check whether the divisions involved in internal transactions follow these procedures
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Transfer-Pricing Example
Two divisions S (seller) and B (buyer) S has a capacity of 100,000 units to make product G Out of pocket costs are $20 per unit of G S is producing at full capacity and can sell all that it can produce in the outside market for $50

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Transfer-Pricing Example
If B wants to buy G from S what is the minimum price at which S should sell? It is $20 out of pocket costs plus $30 opportunity costs The minimum transfer price S should accept is $50 per unit of G

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Transfer-Pricing Example
B has two options It can combine one unit of G with one unit of H (bought from an outside vendor for $30), spend $10 on labor and make one unit of K which it can then sell in the outside market for $125 Alternatively, B can make and sell L for a profit of $25 per unit B can make either 100,000 units of K or L
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Transfer-Pricing Example
If B wants to buy G from S what is the maximum price that B should be willing to pay? Incremental value from transfer is (125-3010) = $85 Opportunity costs for B = $25 (lost profit from L) Maximum price that B would pay for one unit of G = $85-$25 = $60
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Transfer-Pricing Example
B is willing to pay a maximum of $60 S expects a minimum of $50 Do you think the negotiations between B and S will lead to an agreement for transfer of G from S to B? Is this transfer decision optimal from the parent companys perspective?

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Transfer-Pricing Example
What if B can sell L for a profit of $50? Will transfer of G take place? What is the right thing for S to do? For B? Are these decisions, wealth-maximizing from the companys point of view?

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Multinational Transfer Pricing

Additional factors to be considered:
Differences in tax rates, enforcement policies and allowed deductions across various countries Restrictions on dividends and income transfers Tariffs and customs duties Exchange rate fluctuations

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Centralized TP Choices in MNCs

If the marginal tax rate of the selling division is higher than that of the buying division, transfer at the lowest possible price that will be allowed by the tax authorities. Otherwise, transfer at the highest possible price.

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