Transfer pricing

Kumar Fernando

Profit centres and Investment centres

▪ When an organization is divisionalised the managers of the different investment centres are encouraged to operate them as separate economic activities

▪ The authority is delegated to the profit centres or investment centres managers and they are given authority to take decisions at divisional level

▪ Control is applied from HO through performance measurement centre managers and they are held accountable for profits or returns they make

Purposes of decentralization

▪ To give autonomy to local centre managers in decision

making

▪ Motivate centre managers to improve performance and

profitability

▪ Through performance enhancement at a profit centre

level, to achieve better results for the organization as a

whole

▪ Decentralization can create tension between local

centre managers and head office management

▪ Performance of the managers of profit centres and

investment centres will be assessed and the managers

will be rewarded on their performance

▪ Profit centre managers will therefore be motivated to

optimize the results of their own division regardless of

other profit centre and regardless of the organization as

a whole

Head office intervention

▪ When HO management believe that a profit centre manager is taking decisions that improve the profit centre performance but are damaging the organization interest they will step in:

▪ 1. alter the decision that have been made at profit centre level

▪ 2. make new decisions for the profit centre

▪ However if HO intervenes then local autonomy is lost

Transfer pricing

▪ In an organization there will be some inter connection between different centres

▪ Some profit centre will supply goods and service to others

▪ When inter divisional trading takes between profit centres, the centre providing goods or services to the other will want to earn income from the transfer.

▪ Unless it receives income from the transfer it will make a loss on the transaction

▪ Inter divisional transfers must therefore be priced

▪ The price of the transfer is the TRANSFER PRICE

Transfer price

▪ The transfer is treated as an internal sale and an

internal purchase with the organization

▪ It provides sales income to the supplying division and is

a purchase costs for the receiving division

▪ The sales income of one division is offset by the

purchase cost of the other division

▪ The transfer therefore affects the profit of the two

divisions individually

▪ But it will not have an effect on the profit of the

organization as a whole

Inter divisional trading policy

▪ The transfer price for inter divisional transactions is significant because:

▪ It determines how the total profit is shared between the two divisions and

▪ In some circumstances it could affect decisions by divisional managers about whether they willing to sell or buy from the other division

▪ Both divisions must benefit from the transaction if inter divisional sales are to take place

▪ A selling division will not agree to sell items to another division unless it is profitable for the selling division to do so

▪ Similarly a buying division will not wish to purchase items from another division unless it is profitable for the division

Transfer pricing decision

▪ Transfer prices need to be established and

agreed

▪ They could be decided either locally or centrally

▪ Thy could be imposed by HO

▪ Alternatively they could be decided by

commercial negotiation between the profit

centre managers

▪ Inter divisional trading should take place within

a broad company policy

Company policy on transfer pricing

▪ For a selling division given the choice between making a sale to an external customer or supplying goods or services to another division within the group the preference should be to sell internally

▪ For a buying division given the choice of buying from outside or internally the preference should be to purchase internally

▪ However a division should be allowed to sell externally rather than transfer internally or buy externally rather than internally if it has a good commercial reason

▪ Good commercial reasons would include an external customer offering a higher price or an external supplier offering lower price

Objectives of transfer pricing

▪ Goal congruence- Since divisional managers are judged and rewarded for their performance they will act selfishly. The transfer pricing policy should ensure that what is good for an individual division is good for the company as a whole

▪ Performance measurement- The transfer pricing system should result in a report of divisional profits that is a reasonable measure of the managerial performance

▪ Maintaining divisional autonomy- One of the purposes of decentralization is to allow managers to exercise greater autonomy. If transfer pricing is imposed it will affect the autonomy

▪ Minimizing global tax liability- Multinationals use transfer pricing to minimize global tax increases

▪ Recording movement of goods and services

▪ A fair allocation of profits between divisions- Managers should perceive it is fair

▪ Some of these objectives can conflict

Three bases for setting transfer price

▪Market based

▪Cost based

▪Negotiated

Transfer price setting bases

▪ 1. Market based prices- This could be agreed when there is an external market for the transferred item. In this situation selling division can make its profit either by transferring the goods or services internally, or selling them in the external market. Market based transfer could be the market price or at a discount to allow for savings in selling costs.

▪ 2.Cost based transfer price: It could be done at– Marginal cost to the selling division – Marginal cost plus a mark up– Full cost to the selling division– Full cost plus mark upWhen it is based on cost, it could be actual cost or standard costSince standard or budgeted costs are known in advance it can be transferred as it occur

Transfer price base co

ntinued

▪ Actual costs are not known until after the end of the accounting period and thus could delay in pricing transfers and issues

▪ If transfers are done at standard costs the selling division manager could be motivated to improve profits by keeping actual costs below the standard

▪ If it is transferred on actual costs plus mark up then there is no incentive for the selling division manager to reduce the costs

External market (Intermediate market)

▪ The intermediate market for the selling division could be– Perfect– Imperfect– Non existentPerfect market- In a perfect market all suppliers to the market are able to sell their output at prevailing market priceNo individual supplier will dominate and no restriction on demand at this price.Thus the selling division can sell the output at the market price externallyThe only limitation to its profit will be its capacity of the division

Imperfect market

▪ In this market the selling division is unable to sell its entire output a the same market price

▪ For large volumes you need to reduce the prices

▪ In this scenario identifying the interdepartmental transfer price is complex

▪ Demand curve could be plotted to determine the transfer price

Demand curve

▪ Total market demand for an item varies with the sales price

▪ Formula P = a –b*Q P is the price Q is the quantity sold

▪ Example: Division X in T group has an imperfect market for its product. The demand curve is

▪ P= 100- 0.005 Q

▪ This says maximum sales price is 100 but at this price demand will be zero

▪ Each reduction in price of 0.005 sales demand will increase by 1.

▪ At zero price sales will be 20,000

Marginal revenue

▪ MR is the extra revenue that will be earned by selling one additional unit in the market

▪ In a perfect market MR is always the market price of the item because all output can be sold at prevailing market price

▪ In an imperfect market MR is always lower than the market price

▪ P= a – b* Q TR= P*Q

▪ TR= (a-b*Q)*Q TR=aQ- bQ^2

▪ MR= a – 2bQ

▪ Maximum profit when MR=MC

Transfer price decision making

▪ The general rule is that all goods and services

should be transferred at opportunity cost

▪ There are three possible scenarios:

▪ 1. Where there is a perfectly competitive market

for the product

▪ TP= MP

▪ Where the market is perfect but with variable

selling costs

▪ TP= MP –VSC

Transfer price decision where there is surplus capacity

▪ The selling division may have a limit which they can sell externally and it has spare capacity

▪ After meeting external demand if it has still capacity the opportunity costs of transferring units is nil

▪ Here the ideal TP will be marginal cost

▪ Where there are production constraints

▪ Shadow price is the opportunity cost of the lost contribution from the other product or it is the extra contribution that would be earned if more of the scarce resource were available

▪ TP= MC+ Shadow price

Performance evaluation

▪ When TP is market price divisional performance

is likely to represent the real economic

contribution of the division to the company’s

profits.

▪ Where TP is MC it is unlikely to be fair. This

could be mitigated by paying a fixed sum to the

selling division to cover OH and even to make a

profit or make it cost plus

▪ Dual pricing- Where one price is recorded by the

selling division as TP and another price by the

receiving department. The difference is

recorded in HO books

Life cycle considerations for TP

▪ TP tend to vary over product life cycle

▪ During introductory stage TP= Cost plus a profit share or fixed fee

▪ Growth stage- TP= Price of the closest substitute

▪ Maturity stage- TP based on identical product

International transfer pricing

▪ In addition to factors discussed a multinational company will seek to minimize group tax liability through TP

▪ It will reduce the profitability of its subsidiaries in high tax countries and increase profitability in low tax countries

▪ Pre tax profit will be redistributed between subsidiaries

▪ OECD guidelines state where necessary TP should be adjusted using an arms length transaction

▪ Arms length price –a price that would have been arrived by wo unrelated companies

Arms length determination

▪ Tax authorities use three methods to determine arms length transaction

▪ Comparable price method- Setting the arms length price by using the prices of similar products and this method is known as CUPS (comparable uncontrolled prices) and is the preferred method

▪ Where a CUP cannot be found from a retail product available a suitable margin is deducted to arrive at ALP

▪ Here to the manufactured cost a GP margin is added to get ALP

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