Transfer pricing

Transfer Prices

Transfer prices are the amounts charged by one segment of an organization for a product or service that it supplies to another segment of the same organization.

Purpose of Transfer Pricing

Why do transfer-pricing systems exist?

– to communicate data that will lead to goal-congruent decisions

– to evaluate segment performance and thus motivate managers toward goal-congruent decisions

Purpose of Transfer Pricing

Multinational companies use transferpricing to minimize their worldwidetaxes, duties, and tariffs.

Advantages and

disadvantages of basing

transfer prices on total

costs, variable costs,

and market prices.

Transfers at Cost

About half of the major companies in the world transfer items at cost.

Transfers at Cost

Variable costs

Full cost

Full cost plus a profit markup

Standard costs

Actual costs

What are some examples?

Market-Based Transfer Prices

If there is a competitive market for the productor service being transferred internally, usingthe market price as a transfer price willgenerally lead to the desired goalcongruence and managerial effort.

Market-Based Transfer Prices

The major drawback to market-based prices is that market prices are not always available for items transferred internally.

Variable-Cost Pricing

When market prices cannot be used, versions of “cost-plus-a-profit” are often used as a fair substitute.

Variable-Cost Pricing

In situations where idle capacity exists,variable cost would generally be thebetter basis for transfer pricing andwould lead to the optimum decisionfor the firm as a whole.

Negotiated Transfer Prices

Companies heavily committed to segment autonomy often allow managers to negotiate transfer prices.

Dysfunctional Behavior

Virtually any type of transfer pricing policycan lead to dysfunctional behavior – actionstaken in conflict with organizational goals.

The Need for Many Transfer Prices

The “correct” transfer price depends on the economic and legal circumstances and the decision at hand.

Organizations may have to make trade-offs between pricing for congruence and pricing to spur managerial effort.

Factors affecting

Transfer prices.

Multinational Transfer Pricing Example

An item is produced by Division A in a country with a 25% income tax rate.

It is transferred to Division B in a country with a 50% income tax rate.

An import duty equal to 20% of the price of the item is assessed.

Full unit cost is Rs100, and variable cost is Rs60 (either transfer price could be chosen).

Multinational Transfer Pricing Example

Which transfer price should be chosen?

Rs100 Why?

Multinational Transfer Pricing Example

Income of A is Rs40 higher:25% × 40 = (Rs10) higher taxes

Income of B is Rs40 lower:50% × 40 = Rs20 lower taxes

Import duty paid by B:20% × 40 = (Rs8)

Net savings = Rs2

Global Pricing Considerations

Criteria while making Transfer pricing decisions:

a) Tax regimes

b) Local Market conditions

c) Market Imperfections

d) Joint-venture partner

Key drivers behind transfer pricing

in Foreign Countries:

a) Market Conditions

b) Competition

c) Profit for the affiliated) Tax Rates

Key drivers behind transfer pricing

in Foreign Countries:

e) Economic conditions

f) Import Restrictions

g) Customs Duties

h) Price Controls

i) Exchange Controls

Setting Transfer Prices

a) Arm’s length prices:

use of market mechanism as a cue

for setting transfer prices. b) Cost-based pricing (adds a mark-up)