o WHAT IS TRANSFER PRICING?

A Transfer pricing is the internal price charged by a selling

department, division or subsidiary of a company for a raw material , component or finished goods or services which is supplied to a buying department, division or subsidiary of the same company.
The concept of transfer price is fundamentally aimed at

simulating external market conditions within the organization so that the managers of individual business unit are motivated to perform well.

 Transfer pricing is a business tool used by many

companies. This enables companies to keep profits high, no matter what the economy is doing. The objectives of transfer pricing are, therefore, keeping the profit margin high by over charging or under charging on goods and services. Usually this is done when a company has a branches in multiple companies.

 Broadly there are three objectives of transfer pricing:Objective of Transfer Pricing Goal Congruence Performance Appraisal Division Autonomy

1. Goal Congruence:- While designing the mechanism for transfer pricing , the interest of individual profit centers should not supersede those of the organization as a whole. The division manager in maximizing the profits of his/her division should not engage in decision making that fails to optimize the organizations performance.

2. Performance Appraisal:- Transfer pricing should aid in reliable and objective assessment of the activities of profit centers. Transfer prices should provide relevant information to guide decision making , assess the performance of divisional manager and also assess the value added by profit center toward the organization as a whole.

3. Divisional autonomy:- The transfer pricing should aimed at providing optimum divisional autonomy , thereby allowing the benefits of decentralization to be retained . Each divisional manager should be free to satisfy the requirements of his/ her profit center form internal or external sources. There should be no interference in the process by which the buying center manager rationally strives to minimize the

costs and the selling center manager strives to maximize revenues.

 Method of calculating transfer prices:1.

Market-Based Pricing Method:- Organization that uses this method price the goods and services they transfer between their profit centers at a level equal to the prevailing open market price for those goods and services.

2. Negotiated Pricing Method: In this method of transfer pricing , the buying and selling division

negotiate a mutually acceptable transfer prices.

Since each division is responsible for its own performance, this will

encourage cost minimization and encourage the parties to seek a transfer price that yields them an appropriate return.
Tax authorities have reservation about this method because it gives

organization greater scope to manipulate the transfer prices and thus minimize their tax liability.

3. Cost Plus Method:-

It is the simplest method of transfer pricing is to use full historical

cost.
The full cost of product is material , labor and overhead cost required

to produce and ship the product to the buying unit.

Full costs are the most economical transfer prices to develop because

they are routinely prepared for inventory evaluation.

4. Marginal Cost: the marginal cost of a unit is the additional cost required to produce

it.
If the transfer pricing system is designed to ensure efficient allocation

of resources than the best transfer price to use is marginal cost.

At less than full capacity, marginal cost consist of the variable costs

of producing and shipping goods plus any cost directly associated with the transfer.