A Presentation on Transfer Pricing

PREPARED BY: BIJOYEN DAS SEM IV MBA EVENING B K SCHOOL OF MANAGEMENT GUJARAT UNIVERSITY AHMEDABAD BATCH 2010-13

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. Management control systems use transfer prices to coordinate the actions of subunits and to evaluate their performance.

WHAT IS TRANSFER PRICE?

If two or more profit centers are jointly responsible for

product development, manufacturing and marketing, each should share in the revenue generated when the product is finally sold. The Transfer price is the mechanism of distributing this revenue. In above definition, Profit center means a segment of the business entity by which both revenues are received and expenses are incurred or controlled. Narrower definition is used in this chapter.

Transfer Pricing
The transfer price creates revenues for the selling

subunit and purchase costs for the buying subunit, affecting each subunits operating income.
Intermediate Product the product or service

transferred between subunits of an organization.

OBJECTIVES OF TRANSFER PRICES

The Transfer price should be designed so that it accomplishes the following objectives.
Provide each business unit with the relevant information it

needs to determine the trade-off between company costs and revenues. Induce goal congruent decisions. To help measure the economic performance of the individual business units. The system should be simple to understand and easy to administer.

FUNDAMENTAL PRINCIPLE
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. DECISIONS TO BE MADE WHEN INTERDEPARTMENTAL TRADE TAKES PLACE: 1. Sourcing decision 2. Transfer price decision

THE IDEAL SITUATION

Competent people

Good atmosphere
A market price Freedom to source Full information Negotiation

CONSTRAINTS ON SOURCING
LIMITED MARKETS Reasons for limited markets: Limited internal capacity Sole producer Higher investment in facilities
Competitive price: The transfer price that best satisfies the

requirement of a profit centre system. How to find out the competitive price? Use published market prices. Set market prices by bid. Exposure of selling profit centre to outside market. Exposure of buying profit centre to outside market.

EXCESS OR SHORTAGE OF INDUSTRY CAPACITY

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.

Transfer-Pricing Methods

Market-based transfer prices

Cost-based transfer prices Negotiated transfer prices

Transfers at Cost
About half of the major companies in the world transfer items at

cost.

Transfers at Cost

What are some examples? Full cost plus a profit markup Variable costs Standard costs

Actual costs
Full cost

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 the better basis for transfer pricing and would lead to the optimum decision for the firm as a whole.

Cost-Based Transfer Prices

Top management chooses a transfer price based on the

costs of producing the intermediate product. Examples include: Variable Production Costs Variable and Fixed Production Costs Full Costs (including life-cycle costs) One of the above, plus some markup Useful when market prices are unavailable, inappropriate, or too costly to obtain

Market-Based Transfer Prices

If there is a competitive market for the product or service being transferred internally, using the market price as a transfer price will generally lead to the desired goal congruence and managerial effort.

Market-Based Transfer Prices

Top management chooses to use the price of a similar product or

service that is publicly available. Sources of prices include trade associations, competitors, etc. The major drawback to market-based prices is that market prices are not always available for items transferred internally.

Market-Based Transfer Prices

Lead to optimal decision making when three conditions are satisfied: 1. The market for the intermediate product is perfectly competitive 2. Interdependencies of subunits are minimal 3. There are no additional costs or benefits to the company as a whole from buying or selling in the external market instead of transacting internally

Market-Based Transfer Prices

A perfectly competitive market exists when there is a

homogeneous product with buying prices equal to selling prices and no individual buyer or seller can affect those prices by their own actions Allows a firm to achieve goal congruence, motivating management effort, subunit performance evaluations, and subunit autonomy Perhaps should not be used if the market is currently in a state of distress pricing

Market-Based Transfer Prices

When supply outstrips demand, market prices may drop well below their historical average. Distress prices are the drop in prices expected to be temporary.

Negotiated Transfer Prices

Companies heavily committed to

segment autonomy often allow managers to negotiate transfer prices.

Negotiated Transfer Prices

Occasionally, subunits of a firm are free to negotiate the

transfer price between themselves and then to decide whether to buy and sell internally or deal with external parties May or may not bear any resemblance to cost or market data Often used when market prices are volatile Represent the outcome of a bargaining process between the selling and buying subunits

Dysfunctional Behavior

Virtually any type of transfer pricing policy can lead to dysfunctional behavior actions taken in conflict with organizational goals.

Transfer-Pricing Methods Example

TransRef Co. has two divisions: Transportation and Refining. Transportation purchases crude oil in Alaska and sends it to Seattle. Refining processes crude oil into gasoline.

Transfer-Pricing Methods Example

External market price for supplying crude oil per barrel: Transportation Division: Variable cost per barrel of crude oil Fixed cost per barrel of crude oil Total

$13

$ 2 3 $ 5

The pipeline can carry 35,000 barrels per day.

Transfer-Pricing Methods Example

External purchase price for crude oil per barrel: Refining Division: Variable cost per barrel of gasoline Fixed cost per barrel of gasoline Total

$23

$ 8 4 $12

The division is buying 20,000 barrels per day.

Transfer-Pricing Methods Example

The external market price to outside parties is $60 per barrel. The Refining Division is operating at 30,000 barrels capacity per day.

Transfer-Pricing Methods Example

What is the market-based transfer price from Transportation to Refining?

$23 per barrel What is the cost-based transfer price at 112% of full costs?

Transfer-Pricing Methods Example

Purchase price of crude oil Variable costs per barrel of crude oil Fixed costs per barrel of crude oil Total
1.12 $18 = $20.16 What is the negotiated price?

$13 2 3 $18

Between $20.16 and $23.00 per barrel.

Transfer-Pricing Methods Example

Assume that the Refining Division buys 1,000 barrels of crude oil from the Transportation Division. The Refining Division converts these 1,000 barrels of crude oil into 500 gallons of gasoline and sells them. What is the Transportation Division operating income using the market-based price?

Transfer-Pricing Methods Example

Transportation Division: Revenues: ($23 1,000) $23,000 Deduct costs: ($18 1,000) 18,000 Operating income $ 5,000 What is the Refining Divisions operating income using the market-based price?

Transfer-Pricing Methods Example

Refining Division: Revenues: ($60 500) $30,000 Deduct costs: Transferred-in ($23 1,000) 23,000 Division variable ($8 500) 4,000 Division fixed ($4 500) 2,000 Operating income $ 1,000

Transfer-Pricing Methods Example

What is the operating income of both divisions together? Transportation Division $5,000 Refining Division 1,000 Total $6,000

Transfer-Pricing Methods Example

What is the Transportation Divisions operating income using the 112% of full cost price? Transportation Division: Revenues: ($20.16 1,000) $20,160 Deduct costs: ($18.00 1,000) 18,000 Operating income $ 2,160 What is the Refining Division operating income using the full cost price?

Transfer-Pricing Methods Example

Refining Division: Revenues ($60 500) Deduct costs: Transferred-in ($20.16 1,000) Division variable ($8.00 500) Division fixed ($4.00 500) Operating income

$30,000 20,160 4,000 2,000 $ 3,840

Transfer-Pricing Methods Example

What is the operating income of both divisions together? Transportation Division $2,160 Refining Division 3,840 Total $6,000

Avoid making suboptimal decisions when transfer prices are based on full cost plus a markup.

Cost-Based Transfer Prices Example

The Refining Division of TransRef Co. is purchasing crude oil locally for $23 a barrel. The Refining Division located an independent producer in Alaska that is willing to sell 20,000 barrels of crude oil per day at $17 per barrel delivered to the pipeline (Transportation Division).

Cost-Based Transfer Prices Example

The Transportation Division has excess capacity and can transport the crude oil at its variable costs of $2 per barrel. Should TransRef purchase from the independent supplier? Yes. There is a reduction in total costs of $80,000.

Cost-Based Transfer Prices Example

Alternative 1: Buy 20,000 barrels from the local supplier at $23 per barrel. The total cost to TransRef is: 20,000 $23 = $460,000

Cost-Based Transfer Prices Example

Alternative 2: Buy 20,000 barrels from the independent supplier in Alaska at $17 per barrel and transport it to Seattle at $2 per barrel. The total cost to TransRef is: 20,000 $19 = $380,000

Cost-Based Transfer Prices Example

Suppose the Transportation Divisions transfer price to the Refining Division is 112% of full cost. What is the cost to the Refining Division?

Cost-Based Transfer Prices Example

Purchase price of crude oil $17 Variable costs per barrel of crude oil 2 Fixed costs per barrel of crude oil 3 Total $22 1.12 $22 = $24.64

$24.64 20,000 = $492,800

Cost-Based Transfer Prices Example

What is the maximum transfer price? It is the price that the Refining Division can pay in the local external market ($23). What is the minimum transfer price? The minimum transfer price is $19 per barrel.

The range over which two divisions negotiate the transfer price when there is unused capacity

Prorating

TransRef Co. may choose a transfer price that splits on some equitable basis the difference between the maximum transfer price and the minimum transfer price. $23 $19 = $4

Suppose that variable costs are chosen as the basis to allocate this $4 difference.

Prorating

The Transportation Divisions variable costs are $2 1,000 = $2,000. The Refining Divisions variable costs to refine 1,000 of crude oil into 500 barrels of gasoline are $8 500 = $4,000.

Prorating
The Transportation Division gets to keep $2,000 $6,000 $4 = $1.33. The Refining Division gets to keep $4,000 $6,000 $4 = $2.67. What is the transfer price from the Transportation Division? $17.00 + $2.00 + $1.33 = $20.33

Dual Pricing

An example of dual pricing is for TransRef Co. to credit the Transportation Division with 112% of the full cost transfer price of $24.64 per barrel of crude oil. Debit the Refining Division with the market-based transfer price of $23 per barrel of crude oil.

Comparison of Transfer-Pricing Methods

Criteria
Achieves Goal Congruence

MarketBased
Yes, when markets are competitive

Cost- Based
Often, but not always

Negotiated
Yes

Useful for Evaluating Subunit Performance

Yes, when markets are competitive

Difficult unless transfer price exceeds full cost and even then is somewhat arbitrary

Yes, but transfer prices are affected by bargaining strengths of the buying and selling divisions

Comparison of Transfer-Pricing Methods

Criteria
Motivates Management Effort

MarketBased
Yes

Cost- Based
Yes, when based on budgeted costs; less incentive to control costs if transfers are based on actual costs

Negotiated
Yes

Preserves Subunit Autonomy

Yes, when markets are competitive

No, because it is rule-based

Yes, because it is based on negotiations between subunits

Comparison of Transfer-Pricing Methods

Criteria
Other Factors

MarketBased
No market may exist or markets may be imperfect or in distress

CostBased
Useful for determining full cost of products; easy to implement

Negotiated
Bargaining and negotiations take time and may need to be reviewed repeatedly as conditions change

Minimum Transfer Price

The minimum transfer price in many situations should be:
Minimum Transfer Price Incremental cost per unit incurred up to the point of transfer

Opportunity Cost per unit to the selling subunit

Incremental cost is the additional cost of producing and transferring the product or service Opportunity cost is the maximum contribution margin forgone by the selling subunit if the product or service is transferred internally

Administration of transfer prices

Negotiation, Arbitration and conflict resolution, Product classification

Optional use of services

Business unit can procure from outside,

They can develop their own capabilities, They can select not to use services at all

RNRL v/s RIL: A TRANSFER PRICING DISPUTE

THANK YOU