1
Introduction
One of the principal
challenges in operating a
decentralized system is to
devise a satisfactory
method of accounting for
the transfer of goods and
services from one profit
center to another in
companies that have a
significant number of these
transactions
2
Objectives of Transfer Pricing
The transfer price should be
designed so that it accomplishes
the following objectives :
• It should provide each business unit with the
relevant information it needs to determine
the optimum trade off between company
costs and revenue.
• It should induce goal congruence decisions.
• It should help measure the economic
performance of the individual business units.
• The system should be simple to understand
and easy to administer.
3
Transfer Pricing Methods
Transfer Price is to refer to the
amount used in accounting for
any transfer of goods and
services between
responsibility centers.
4
Transfer Pricing Methods
Fundamental Principles
The fundamental principle 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 vendors
When profit centers of a company buy products from, and
sell to, one another, two decisions must be made
periodically for each product :
1. Should the company produce the product inside the
company or purchase it from an outside vendor ?. This
is the sourcing decision.
2. If produced inside, at what price should the product be
transferred between profit centers ?. This is the
transfer price decision.
5
Transfer Pricing Methods
The Ideal Situation
A market price based, transfer price will induce
goal congruence if all the conditions listed
below exist :
a. Competent People
• Managers should be interested in long run as
well as the short run performance of their
responsibility centers.
b. Good Atmosphere
• Managers must regard profitability as measured
in their income statements, as an important
goal.
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Transfer Pricing Methods
The Ideal Situation
c. A Market Price
• The ideal transfer price is based on a well
established, normal market price for the
identical product being transferred, a market
price reflecting the same conditions (quantity,
quality) as the product to which the transfer
price applies.
d. Freedom to Source
• Alternatives for sourcing should exist, and
managers should be permitted to choose the
alternative that is in their own best interests.
7
Transfer Pricing Methods
If all of the
conditions
are exist,
a transfer
price
system
based on
market
prices
would
induce
goals
congruenc
e decisions
The Ideal Situation
e. Full Information
• Managers must know about the
available alternatives and the
relevant costs and revenues of
each
f. Negotiation
• There must be a smoothly working
mechanism for negotiating
“contracts” between business
units
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Transfer Pricing Methods
Constraints on Sourcing
 Ideally, the buying manager
should be free to make
sourcing decisions. Similarly,
the selling manager should be
free to sell products in the
most advantageous market
 In real life, however, freedom
to source might not be
feasible or, if it is feasible,
might be constraint by
corporate policy.
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Transfer Pricing Methods
Constraints on Sourcing
Limited Market
In many companies, markets for the buying or
selling profit centers may be limited, because of
• The existence of internal capacity might limit
the development of external sales.
• If a company is the sole producer of a
differentiated product, no outside source exists.
• If a company has invested significantly in
facilities, it is unlikely to use outside sources
unless the outside selling price approaches the
company’s variable cost.
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Transfer Pricing Methods
Constraints on Sourcing
How does a company find out what the
competitive price is if it does not
buy or sell the product in an outside
market ?. Here are some ways :
 If published market prices are
available, they can be used to
establish transfer prices.
 Market prices may be set by bids.
This generally can be done only if
the low bidder stands a reasonable
chance of obtaining the business.
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Transfer Pricing Methods
Constraints on Sourcing
 If the production profit center
sells similar products in outside
markets, it is often possible to
replicate a competitive price on
the basis of the outside price
 If the buying profit center
purchases similar products from
the outside market, it may be
possible to replicate
competitive prices for its
proprietary products.
12
Transfer Pricing Methods
Constraints on Sourcing
Excess or Shortage of Industry Capacity
 Some companies allow either the buying or
selling profit center to appeal a sourcing
decision to a central person or committee
 If there are constraints on sourcing, the
market price is the best transfer price. If the
market price exists or can be approximated,
use it.
 However, if there is no way of approximating
valid competitive prices, the other option is to
develop cost based transfer prices.
13
Transfer Pricing Methods
Cost Bases Transfer Prices
If competitive prices are not
available, transfer prices may be
set on the basis of cost plus a
profit, even though such transfer
prices may be complex to calculate
and the results less satisfactory
than a market price.
The two decisions must be made in a
cost based transfer price system :
a. How to define cost
b. How to calculate the profit markup
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Transfer Pricing Methods
Cost Bases Transfer Prices
The Cost Basis
The usual basis is standard costs.
Actual costs should not be used
because production
inefficiencies will be passed on
to the buying profit center. If
standard costs are used, an
incentive is needed to set tight
standards and improve
standards.
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Transfer Pricing Methods
Cost Bases Transfer Prices
The Profit Markup
In calculating the profit markup,
there also are two decisions :
a. What the profit markup is based
on
b. The level of profit allowed
• The simplest and most widely used
base is a percentage of costs.
• A conceptually better base is
percentage of investment.
16
Transfer Pricing Methods
Upstream Fixed Costs and Profits
Transfer pricing can create a significant problem
in integrated companies. The profit center
that finally sells to the outside customer may
not even be aware of the amount of upstream
fixed costs and profit included in its internal
purchase price. Methods that companies use
to mitigate this problem, are :
a. Agreement Among Business Units
b. Two Step Pricing
c. Profit Sharing
d. Two Sets of Prices
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Transfer Pricing Methods
Upstream Fixed Costs and
Profits
a. Agreement Among Business
Units
Some companies establish a formal
mechanism whereby representatives
from the buying and selling units meet
periodically to decide on outside
selling prices and the sharing of
profits for products with significant
upstream fixed costs and profit
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Transfer Pricing Methods
Upstream Fixed Costs and
Profits
b. Two Step Pricing
Establish a transfer price that
includes two charges :
• For each unit sold, a charge is
made that is equal to the standard
variable cost of production.
• A periodic charge is made that is
equal to the fixed costs associated
with the facilities reserved for the
buying unit.
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Transfer Pricing Methods
Business Unit X (manufacturer)
Product A
Expected monthly sales to business unit Y
Variable cost per unit
Monthly fixed costs assigned to product
Investment in working capital and facilities
Competitive return on investment per year
5,000 units
$ 5
20,000
1,200,000
10 %
One way to transfer product A to business unit Y is at price
per unit, calculated as follows :
Variable cost per unit
Plus fixed cost per unit
Pus profit per unit
Transfer price per unit
Transfer price for product A
$
5
$ 4
$
2
$ 11
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Transfer Pricing Methods
Correction by two step pricing :
Transfer price for product “A” $ 5 + $ 20,000/month
fixed cost + $ 10,000 per month for profit :
$ 1,200,000 x 0.10 = 10,000
12
Unit “Y” will pay the variable cost of
(5,000 unit x $ 5/unit)
:
$ 25,000
Plus fixed cost and profit :
$ 30,000
Total
$ 55,000
Unit “X” will pay $ 11/unit (5.000 unit x $ 11 = $ 55,000)
If transfers in another month were 4,000 units, Unit “Y”
would pay $ 50,000 [(4,000 unit x $ %) + $ 30,000],
under two step pricing, compared with $ 44,000 ($ 11 x
4,000 unit).
The difference is penalty for not using a portion of unit X’s
capacity that it has reserved.
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Transfer Pricing Methods
Upstream Fixed Costs and
Profits
c. Profit Sharing
The system operates as follows :
• The product is transferred to the
marketing unit at standard variable cost
• After the product is sold, the business
units share the contribution earned,
which is the selling price minus the
variable manufacturing and marketing
costs.
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Transfer Pricing Methods
Upstream Fixed Costs
and Profits
d. Two Sets of Prices
The manufacturing unit’s
revenue is credited at the
outside sales price and the
buying unit is charged the total
standard costs. The difference
is charged to a headquarters
account and eliminated when
the business unit statements
are consolidated.
23
Pricing Corporate Services
There remain two types of
transfers :
1. For central services that
the receiving unit must
accept but can at least
partially control the
amount used.
2. For central services that
the business unit can
decide whether or not to
use.
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Pricing Corporate Services
Control Over Amount of Service
Business unit may be required to use company
staffs for services such as IT and R&D.
There are three schools of thought about such
services.
1. A business unit should pay the standard
variable cost of the discretionary services.
2. A price equal to the standard variable cost
plus a fair share of the standard fixed costs,
that is, the full cost.
3. A price that is equivalent to the market price
or to standard full cost plus a profit margin.
25
Pricing Corporate Services
Optional Use of
Services
In some cases,
management may decide
that business units can be
choose whether to use
central service units.
Business units may procure
the service from outside,
develop their own
capability, or choose not
to use the service at all.
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Pricing Corporate Services
Simplicity of the Price
Mechanism
The prices charged for
corporate services will not
accomplish their intended
result unless the methods
of calculating them are
straightforward enough
for business unit managers
to understand them.
27
Administration of Transfer Prices
Negotiation
In most companies, business
units negotiate transfer prices
with each other, that is, transfer
prices are not set by a central
staff group.
The most important reason for
this is the belief that
establishing selling prices and
arriving at satisfactory purchase
prices are among the primary
functions of line management.
28
Administration of Transfer Prices
Arbitration and Conflict Resolution
A procedure should be in place for arbitrating
transfer price disputes.
Example :
• Arbitrating is assigned to single executive.
• Set up a committee.
Usually such a committee will have three
responsibilities :
a. Settling transfer price disputes
b. Reviewing sourcing changes
c. Changing the transfer price rules when
appropriate.
29
Administration of Transfer Prices
Arbitration and Conflict Resolution
Arbitration can be conducted in a number of
ways. With a formal system, both parties
submit a written case to the arbitrator.
The arbitrator reviews their positions and
decides on the price.
There are four ways to resolve conflicts :
• Forcing
• Smoothing
• Bargaining
• Problem Solving
30
Administration of Transfer Prices
Product Classification
The extent and formality of the sourcing and
transfer pricing rules depend to a large extent
on the number of intra company transfers and
the availability of markets and market prices.
Some companies divide products into two main
classes :
• Classes I, includes all products for which senior
management wishes to control sourcing
• Classes II, is all other products. In general,
these are products that can be produced
outside the company without any significant
disruption to present operations.
31
General Considerations
Conditions for Delegating Profit
Responsibility
Before delegate expense/revenue trade off
decision to a lower level manager, two
conditions should exists :
a. The manager should have access to the
relevant information needed for making
such a decision
b. There should be some way to measure the
effectiveness of the trade offs the manager
has made
32
General Considerations
Conditions for Delegating Profit
Responsibility
Before delegate expense/revenue trade off
decision to a lower level manager, two
conditions should exists :
a. The manager should have access to the
relevant information needed for making
such a decision
b. There should be some way to measure the
effectiveness of the trade offs the manager
has made
33
General Considerations
Advantages of Profit Centers
• The quality of decisions may improve because
they are being made by managers closest to the
point of decision.
• The speed of operating decisions may be
increased since they do not have to be referred
to corporate headquarters.
• Headquarters management, relieved of day to
day decision making, can concentrate on
broader issues.
• Managers, subject to fewer corporate restraints,
are freer to use their imagination and initiative.
34
General Considerations
Advantages of Profit Centers
• Profit centers provide an excellent training
ground for general management.
• Profit consciousness is enhanced since managers
who are responsible for profits will constantly
seek ways to increase them.
• Provide top management with ready made
information on the profitability of the
company’s individual components.
• Because their output is so readily measured,
profit centers are particularly responsive to
pressures to improve their competitive
performance.
35
General Considerations
Example
• ABB (Asea Brown Boveri), a european
multinational in the business of power
generation, transmission and distribution, was
organized into 4,500 small profit centers, each
with profit and loss responsibility and
meaningful autonomy.
• Many Japanese companies use profit centers.
The Kyocera Corporation, a technology
company, divided itself into 800 small
companies (nicknamed amoeba), which were
expected to trade both internally and externally
36
General Considerations
Difficulties with Profit Centers
 Decentralized decision making will force top
management to rely more on management
control reports than on personal knowledge of
an operation.
 If headquarters management is more capable
than the average profit center manager, the
quality of decisions made at the unit level may
be reduced.
 Friction may increase of arguments over the
appropriate transfer price.
 Competent general managers may not exist in a
functional organization
General Considerations
Difficulties with Profit Centers
 Organization units that once cooperated as
functional units may now be in competition with
one another.
 Divisionalization may impose additional costs
because of the additional management, staff
personnel etc.
 There is no completely satisfactory system for
ensuring that optimizing the profits of each
individual profit center will optimize the profits
of the company as a whole.
 There may be too much emphasis on short run
profitability at the expense of long run
profitability.
37
38
Business Unit as Profit Centers
Most business units
are created as profit
centers since
managers in charge
of such units
typically control
product
development,
manufacturing and
marketing resources.