Methods of TP

II ) Cost Based TP: -

A) Variable Cost as TP: -

● TP be set at Variable cost of production of Div A

* Rational - After all FC is a sunk cost for Div A.

This TP forces Div A to not to earn any profit but

also not to recover even its operating cost.
But from company wide perspective this TP is best

10/17/08 hmahesh45@yahoo.com; VIM Pune 1

 Methods of TP
II ) Cost Based TP: -

B) Full Cost/Absorption Cost: -

● TP is set at VC + FC of production of Div A.
This gives an opportunity to Div A to recover
its operating cost
* In this approach FC of Div A appears as VC of Div B,
In a broader perspective of firm it is wrong conception.
* Such conception may leads to incorrect decision
on the part of Div B and subverts the firm’s goal.
* Do not provide any incentive for cost control.
(since actual cost = TP).

10/17/08 hmahesh45@yahoo.com; VIM Pune 2

 Methods of TP
II ) Cost Based TP: -

C) Standard Cost as TP: -

● Actual Cost as TP leads to passing

inefficiencies of Div A to Div B therefore …….

* Scientifically Predetermined product cost

would be a better yard stick to control actual cost.
* Ensures operating efficiency of Div A by motivating it
to contain its actual cost in predetermined limit.

10/17/08 hmahesh45@yahoo.com; VIM Pune 3

 Methods of TP
II ) Cost Based TP: -

D) Modified Cost as TP: -

● Mere recovery of Cost does not provide any profit
perspective to Div A. It lacks motivation for Div A to earn
profit.

Therefore TP can be set as:-

TP = Cost + Mark up
{Markup = Certain % of cost or lump sum amount}
• However taking cost as actual cost again introduces its
inherent drawback.
Therefore best approach would be
TP = Std. Cost + Markup

10/17/08 hmahesh45@yahoo.com; VIM Pune 4

 General Rule for TP
Minimum TP = VC per unit + Contribution lost per unit

Div A must recover its entire VC and also the

Contribution lost.

(Contribution Lost – the amount that Div A would

otherwise have earned through selling in external market)
● This makes Div A indifferent as to the
sale to outsider or inter divisional transfer

10/17/08 hmahesh45@yahoo.com; VIM Pune 5

 Conclusion on Transfer Pricing

Highest TP = Market Price

Lowest TP = Variable Cost

Min. TP = VC + Contribution Lost

10/17/08 hmahesh45@yahoo.com; VIM Pune 6

 Thanks………

10/17/08 hmahesh45@yahoo.com; VIM Pune 7

 Methods of TP-
Other Approaches to Transfer Pricing
I) Two Step Pricing
Div A will Charge actual Variable Cost (based on actual volume)
Plus (based on agreed upon volume) agreed amount
will be charged per PERIOD basis (to compensate (FC + Profit) )
II) Profit Sharing
Div A will transfer the product at standard variable cost
to Div B. After selling the final product, the contribution
earned by Div B will be shared by both.

III) Two Sets of Prices

Credit the A’s account by MP
Charge Total Std.Cost to B’s account &
Charge the difference to HQ account.
While consolidating the BU accounts reverse the difference.
10/17/08 hmahesh45@yahoo.com; VIM Pune 8
 Considerations in –
Transfer Pricing in MNC’s -
1. Taxation – tax heavens, double taxations
2. Govt. Regulations – Arms length price (in
absence of which BU can set TP to minimize
the tax liability)
3. Tariffs – They are certain % of import value,
therefore lower the TP lower will be the tariffs.
4. Foreign Exchange Control – e.g. limit on FE
spending for import.
5. Shifting of funds to desired location.
6. Joint Ventures – May enforce the specific TP.
10/17/08 hmahesh45@yahoo.com; VIM Pune 9
7. Transaction, Operation and Economic