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SUBJECT COMMERCE
Paper No and Title 06: ACCOUNTING FOR MANAGERIAL DECISIONS
Module No and Title 05: PROBLEMS IN TRANSFER PRICING
Module Tag COM_06_05_ETEXT
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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TABLE OF CONTENTS
1. Learning outcomes
2. Introduction
3. Concept of transfer pricing
4. Objective of sound transfer pricing system
5. Different methods of transfer pricing
6. Rules for successful transfer pricing
7. Various problem associated with transfer pricing
8. Summary
LEARNING OUTCOMES
After studying this module, you shall be able to:
Learn the concept of transfer pricing
Objective of sound transfer pricing system
Methods of transfer pricing
Rules for successful transfer pricing
Problems associated with transfer pricing
Practical application on transfer pricing
2. INTRODUCTION
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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Transfer pricing is a profit allocation method used to
assign an MNE’s net profit (or loss) before tax to the countries where its business activity is conducted. Transfer
pricing involves the setting of prices among divisions within an enterprise. Transfer prices are charges for goods
and services between controlled (or related) legal entities within an enterprise. The branches and companies that
are wholly or majority owned ultimately by the parent corporation are considered as legal entities under the
control of a single corporation.
Transfer pricing is a unique methodology to transfer the goods from one company division or department
to another which entails minimal postings on the accounts receivable and accounts payable books. It is a process
that greatly simplifies the process.
Normally, there is a simple form that accompanies the physical transfer of the goods, and it is
used by both the sender and the recipient to make appropriate posts in company accounting records. This
process eliminates the necessity for invoices, tariffs, internal bills of lading, and other documents that
would normally apply to a new purchase using an outside vendor.
While the main purpose of transfer pricing is to enhance the overall value of the corporate family
of companies, there are instances when this type of transaction can be abused. This is especially true when
transfers to international locations are conducted. Today, many countries have regulations to help prevent
the use of this pricing method as a means of evading taxes or similar unethical and illegal activities.
3. CONCEPT OF TRANSFER PRICING
Transfer pricing is a profit allocation method used to attribute a multinational corporation's net profit
(or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among
divisions within an enterprise. Transfer prices are charges for goods and services between controlled (or
related) legal entities within an enterprise. Legal entities considered under the control of a single corporation
include branches and companies that are wholly or majority owned ultimately by the parent corporation.
A transfer pricing is the notional value at which goods and services are transferred from one division or
department to another within a decentralized organization. Transfer prices are normally set for intermediate
products which are goods and services that are supplied by the selling division to the buying division. The goods
that are produced by the buying division and sold to the outside world are known as final products.
The price charged to the interdivisional transfer of goods and services is revenue to the selling division
and cost to the buying division. Therefore, the price charged is bound to affect the profits of both the divisions;
benefit (revenue) to one division will be created at the expense of the other division. For example, the selling
division will benefit from charging prices for such transfers of goods and services. However, for the buying
division, this will result into higher costs. The transfer prices, thus, can have impact on the evaluation of each
division’s performance and measures applied for such measurement of performance.
4. OBJECTIVES OF A SOUND TRANSFER PRICING SYSTEM
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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Transfer pricing should help in the accurate measurement of
divisional performance (profitability) measurement
Transfer pricing should motivate the divisional managers into maximizing the profitability of their
divisions and making decisions that are in the best interests of the organizations as a whole
Transfer prices should ensure that the divisional autonomy and authority remains well intact.
Transfer prices should allow goal congruence to take place, which in effect means that the objectives of
divisional managers are compatible with the objectives of overall company.
A transfer pricing system, if duly established, can keep a vigil on the multinational companies and
international groups which may try to falsify the transfer prices between countries in order to curtail the
overall tax burden and take the required action, as may be required.
To ensure that the information provided (e.g., division Profit & Loss Accounts) is useful for evaluating the
economic performance of divisions and the managerial performance of division managers
Transfer prices should be such that actions which will have the effect of increasing a division’s reported
profit will also have the effect of increasing the company’s reported profit
MNEs use various market-based and cost-based transfer pricing mechanisms to accomplish the objective of
goal congruence. Transfer-pricing system must, however, have in-built mechanisms to ensure smooth
negotiation and conflict resolution.
5. DIFFERENT METHODS OF TRANSFER PRICING
METHODS FOR
TRANSFER
PRICING
MARKET COST-BASED NEGOTIATED
DUAL PRICES
PRICES PRICES PRICES
MARKET PRICES
Market price refer to a price in an intermediate market between independent buyers and seller
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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In competitive external market for the transferred
product, market prices work well as transfer prices
In market price, divisional performance is more likely to represent the real economics contribution of the
division to total company profit
Market-prices are based on opportunity costs concept
In market price, no division can be benefit at the expense of another division
Managers of both buying and selling divisions are indifferent between trading with each other or with
outsiders
In market transfer pricing, minimum transfer price for the selling division is the market price and maximum
transfer price for the buying division is also the market price
The market price can resolve conflicts among the buying and selling divisions
Market price is the optimal so long as the selling division is operating at full capacity
Finding a competitive market price may be difficult if such a market does not exist
Market price may change often that why it is very cumbersome used as a transfer price
Problem with market prices can occur when a selling division is not operating at full capacity and cannot
sell all its products
COST-BASED PRICES
When external market do not exist or are not available to the company or when information about external
market prices is not readily available, companies may decide to use some form of cost-based transfer
pricing system
Variable cost-based pricing approach is useful when selling division is operating below capacity
The manager of selling division will generally not like this transfer price because it yields no profit to that
division
In actual full cost approach, transfer price is based on the total product cost per unit which will include
direct material, direct labour and factory overhead
A full cost transfer price would have shut down the chances of any negotiation between divisions about
selling at transfer prices
Standard cost-based pricing approach is useful & reduces risk to the buyer
Transfer pricing based on opportunity cost identifies the minimum price that a selling division would to
accept and the maximum price that the buying division will be willing to pay
The opportunity cost approach is used in situation where the market is imperfect
A transfer is in the best economic interest of the company if the opportunity cost for the selling division is
less than the opportunity cost for the buying division
NEGOTIATED PRICES
Negotiated prices are generally preferred as a middle solution between market prices and cost-based prices
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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Under negotiated prices, the managers involved act much the
same as the manager of independent companies
Negotiation strategies may be similar to those employed when trading with outside markets
Negotiated prices avoids mistrust, bad feeling and undesirable bargaining interests among divisional
managers
It provide an opportunity to achieve the objectives of goal congruence autonomy and accurate performance
evaluation
The overall company is beneficial if selling and buying divisions can agree upon some mutually transfer
prices
The agreed prices also can be used for performance measurement without creating any friction
The use of negotiated prices is consistent with the concept of decentralized decision-making in the
divisionalised firms.
In negotiated transfer price, a great deal of management effort, time and resources can be consumed in the
negotiating process.
In negotiated transfer price, one divisional manger having some private information may take advantage of
another divisional manager.
DUAL PRICE
Dual prices of transfer pricing, selling division sells the transferred goods at a profit using full cost plus
profit margin.
Transfer price for the buying division is the market price.
The difference in transfer prices for the two divisions could be accounted for by special centralized
account.
Dual pricing system has the function of motivating both the selling division and buying division to make
decisions that are consistent with the overall goals of decentralization goal congruence, accurate
performance measurement, autonomy, adequate motivation to divisional manager.
Dual prices provides incentive to selling divisions in the form of the profit or mark up at which the goods
are transferred.
Q1. A company has two divisions, A and B. the division A is currently operating at full capacity. It has been
asked to supply its product to division B. division A sells its product to its regular customers for Rs. 30 each.
Division B (currently operating at 50% capacity) is willing to pay Rs. 20 each for the component produced by
division A (this represents the full absorption cost per component at division A)
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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The components will be used by division B in
supplementing its main product to conform to the need of special order.
As per the contract terms of sales, the buyer calls for reimbursement of full cost to division B plus 10%
Division A has a variable cost of Rs. 17 per component. The cost per unit of division B subsequent to the
buying part from division A is estimated as follow:
Purchased parts- outside vendors Rs.90
Purchase part – division A Rs. 20
Other variable costs Rs. 50
Fixed overheads and administration Rs. 40
---------
Rs.200
The company uses return on investment in the measurement of division and division manager’s performance.
Required:
(a) As manager of division A, would you recommend sales of your output to division B at the stipulated price of
Rs. 20?
(b) Would it be in the over-all interest of the company for division A to sell its output to division B?
(c) Suggests an alternative transfer price and show how could it lead to goal congrenuence?
Solution:
(a) As manager of division A, sales at Rs. 20 per unit to division B, should not be recommended. The division is
already operating at its full capacity and the market is presumably absorbing all its output at Rs. 30 per unit.
(b) Decision analysis (whether to transfer part from division A to division B of Rs. 20 per unit or not)
Particulars Sold externally Transferred to
(Rs.) division B (Rs.)
COMMERCE PAPER No. : 06 ACCOUNTING FOR MANAGERIAL
DECISIONS
MODULE No.5: PROBLEMS IN TRANSFER PRICING
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Sale price (division A) 30
Sale price (division B) (RS.200+10%) 220
Less: relevant incremental cost
For part of division A (17) (17)
Purchased parts from outside ---- (90)
Other valuable costs ---- (50)
Profit per unit 13 63
It will be in the over-all interest of the company that the transfer takes place as it would increase the firm’s profit
by Rs. 50 per unit.
(c) Dual price basis of effecting transfer is the most appropriate. In this case, the relevant transfer price will be Rs.
30 (sale) so far as division A concerned and Rs. 20 (purchase) so far as division B is concerned. It will keep the
profits of division A unaffected and will facilitate the utilization of idle capacity of division B, as also increase its
profit:
Sale price (Rs. 210+10%) Rs. 231
Less: costs (Rs. 90 + 50) (Rs.140)
Profit Rs. 91
6. RULES FOR SUCCESSFUL PRICING
It should be simple to understand and easy to operate
It should enable fixation of fair transfer prices for the output transferred or service rendered
Ideally the business unit/divisional manager must be given autonomy and freedom to sell in open market
The business unit/divisions should have free access to various sources of market information
There should be a negotiation for transfer prices between the business unit/divisional managers of the
selling business unit/division
COMMERCE and the buying
PAPER No. unit/division
: 06 ACCOUNTING FOR MANAGERIAL
Negotiated transfer prices are far more
DECISIONS motivating than the prices imposed by the top management or
determined by the finance department
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Sound transfer pricing ground rules must be framed to guide negotiations between business unit/divisional
manager
It must promote consistency in transfer pricing decisions, but also minimize interdivisional conflicts
A system of arbitration with ground rules must also be established
Top management should discourage prolonged arguments between business unit/divisional manager
Transfer prices can be reviewed annually or as dictated by the demand and supply conditions in the market
Transfer pricing guidelines must state the circumstances under which a revision of transfer prices can be
made during the year
When transfer prices are based on market price, long-run competitive/normal prices must be considered
Transfer pricing and arbitration rules can be reviewed once in four years or earlier if there is a major
change in business conditions
7. VARIOUS PROBLEMS ASSOCIATED WITH TRANSFER PRICING
“Transfer pricing” as shorthand for multinational corporations shifting profits to tax havens to avoid tax in
developed countries
If a division is transferring goods to another division located in a high tariff country, a low transfer price
reduce the tariff
A company can shift income from a division (foreign country) to itself (home country) by charging a
management fee
In transfer pricing, the reported performance of the local managers is influenced by corporate policies
8. SUMMARY
Transfer pricing is a profit allocation method used to attribute a multinational corporation's net profit
(or loss) before tax to countries where it does business.
Transfer pricing results in the setting of prices among divisions within an enterprise.
Transfer prices are charges for goods and services between controlled (or related) legal entities within
an enterprise.
Legal entities considered under the control of a single corporation include branches and companies that
are wholly or majority owned ultimately by the parent corporation
The price charged to the interdivisional transfer of goods and services is revenue to the selling division
and cost to the buying division.
Therefore the price charged will affect the profit of both divisions; benefit (revenue) to one division
can be created only at the expense
COMMERCE PAPER of the other: division
No. 06 ACCOUNTING FOR MANAGERIAL
Transfer pricing should helpDECISIONS
in the accurate measurement of divisional performance (profitability)
measurement
MODULE No.5: PROBLEMS IN TRANSFER PRICING
Transfer pricing should motivate the divisional managers into maximizing the profitability of their
divisions and making decisions that are in the best interests of the organizations as a whole
Transfer prices should ensure that divisional autonomy and authority is preserved
Transfer prices should allow goal congruence to take place, which in effect means that the objectives
