Description
This is a presentation that includes the entire basics of Transfer Pricing.
TRANSFER PRICING
Objectives of Transfer Prices
•
It should provide each business unit with relevant information needed to determine optimum trade-off between company costs and revenues • It should induce goal congruent decisions • It should help measure economic performance of individual business units • System should be simple to understand and easy to administer • If two or more profit centers are jointly responsible for product development, marketing and manufacturing, each should share in revenue
Transfer Pricing Methods
•
Transfer price is referred to the amount used in accounting for any transfer of goods and services between responsibility centers • One of the two parties involved is a profit center • Fundamental Principle: ? transfer price should be similar to price that would be charged if product were sold to outside customers or purchased from outside vendors ? Classical economics talks on selling prices equal to marginal costs and some authors advocate transfer price based on marginal cost
Transfer Pricing Methods
two decisions must be made periodically for profit centers to buy and sell products from one another: sourcing decision transfer price decision • Ideal Situation: ? competent people: Staff people involved in negotiation & arbitration ? good atmosphere: profit as significant consideration in performance
?
Transfer Pricing Methods
a market price: should reflect same conditions e.g. quantity, delivery time and quality Adjusted downwards to reflect savings to selling units from internal dealings e.g. no bad debts ? freedom to source: manager of each profit center has the right to deal with either insiders or outsiders at his or her will ? full information: Relevant alternatives and related costs & revenues
?
Transfer Pricing Methods
negotiation: a smooth working mechanism for contracts • Constraints on Sourcing: ? limited markets: existence of internal capacity might limit development of external sales if company is sole producer of a differentiated product, no outside source exists If a company has invested in facilities, outside sources will not be used unless selling price approaches company’s variable cost
?
Transfer Pricing Methods
competitive pricing, which can best satisfy profit center requirements, measures contribution of each profit center to total company profits ? Some ways to find competitive price are: ? based on published market prices ? set by bids ? for a production profit center selling similar products in outside market ? for a buying profit center purchasing similar products from outside market
Transfer Pricing Methods
excess or shortage of industry capacity: excess capacity – selling profit center cannot sell to outside market shortage of capacity – buying profit center cannot obtain product it requires from outside Even if no. of intracompany transfers is significant some senior management do not intervene on the theory that benefits of keeping profit centers independent offset loss from suboptimising company profits
?
Transfer Pricing Methods
Some companies allow either buying or selling profit center to appeal a sourcing decision to a central person or committee Given the option, buying profit center would prefer to deal with an outside source If the market price exists or can be approximated, use it In transfer pricing calculation, companies avoid advertising, financing & other expenses that seller does not incur in internal deal and same benefits pass on to the buyer also
Transfer Pricing Methods
•
Cost-based transfer prices: ? cost basis: standard costs should be used so that production inefficiencies are eliminated ? profit mark-up: base of mark-up and level of profit allowed base – % of costs v/s % of investment conceptual solution is to base profit allowance on investment ( at standard level), required to meet volume needed by buying profit centers
Transfer Pricing Methods
•
Upstream Fixed Costs and Profits: ? agreement among business units: Some companies establish a formal mechanism where representatives from buying & selling units meet periodically to decide on outside selling prices and sharing of profits for products with significant upstream fixed costs and profit This mechanism will work only when review process allows significant business to atleast one of the profit centers
Transfer Pricing Methods
two-step pricing: first, for each unit sold, a charge equal to standard variable cost of production is taken a periodic charge is made equal to fixed costs associated with facilities reserved for buying unit It would be appropriate under some circumstances to divide investment into variable (e.g. receivables and inventory) and fixed (e.g. plant) components Then a profit allowance based on return on variable assets would be added to standard variable cost for each unit sold
?
Transfer Pricing Methods
Following are some points about above method: ? monthly charge for fixed costs and profit should be negotiated periodically & will depend on capacity reserved for buying unit ? questions may be raised about accuracy of cost and investment allocation ? manufacturer’s unit profit allowance is not affected by sales volume of final unit ? conflict between interests of company and manufacturing unit ? this method is similar to “take or pay pricing”
Transfer Pricing Methods
profit sharing: this system can induce goal congruence between business unit and company interests here, product is transferred to marketing unit at standard variable cost after product is sold, business units share contribution earned, which is selling price minus variable manufacturing and marketing costs This method is useful if demand for manufactured product is not steady enough to warrant permanent assignment of facilities
?
Transfer Pricing Methods
this method has some practical problems: There can be arguments over contribution divided over two profit centers; this is costly and time-consuming for management to intervene Arbitrarily dividing up profits among units does not give valid information on unit’s profitability Since contribution is not allocated until sale is made, manufacturing unit’s contribution depends on marketing unit’s ability to sell as well as the actual selling price
Transfer Pricing Methods
two sets of prices: In this method, manufacturing unit’s revenue is credited at outside sales price and buying unit is charged total standard costs Difference is charged to a headquarters account and eliminated when business unit statements are consolidated This method is sometimes used when there are frequent conflicts between buying & selling units that cannot be resolved by one of other methods; both units benefit under such arrangement
?
Transfer Pricing Methods
There are some disadvantages to this method: Sum of business unit profits is greater than overall company profits This system creates an illusive feeling that business units are making money System might motivate business units to concentrate more on internal transfers There is additional bookkeeping involved Fact that conflicts would be reduced here can be taken as a weakness
Pricing Corporate Services
•
If these costs are charged at all, they are allocated and allocations do not include a profit component • There are mainly two types of transfers: ? for central services that receiving unit must accept but can atleast partially control amount used ? for central services that business unit can decide whether or not to use • Control over amount of service: ? business units can use company staffs for IT services and R & D, efficiency can’t be controlled
Pricing Corporate Services
one school of thought says that business unit should pay standard variable cost of discretionary services ? second school of thought advocates a price equal to standard variable cost plus a fair share of standard fixed costs – i.e. full cost ? third school advocates a price that is equivalent to market price or to standard full cost plus a profit margin • Optional use of services: ? often used for IT, maintenance, consulting groups and maintenance work.
?
Pricing Corporate Services
in some cases, management may decide that business units can choose whether to use central service units ? business units may procure service from outside, develop their own capability or choose not to use the service at all • Simplicity of pricing mechanism: ? prices charged for corporate services needs straight methods to be calculated ? computer experts are used as they already solve complex equations
?
Administration of Transfer Prices
•
Negotiation: ? in most companies, transfer prices are decided by business units on negotiated basis ? also, many transfer prices require a degree of subjective judgment. ? business unit usually have best information on markets and costs and consequently, are best able to arrive at reasonable prices. ? business unit must know ground rules for negotiation of transfer prices.
Administration of Transfer Prices
in some companies, headquarters inform units that they are free to deal with one another or with outsiders, subject to qualification that if there is a tie, business must be kept inside ? line managers should not spend time on transfer price negotiations • Arbitration and Conflict Resolution: ? a procedure should be in place for arbitrating price disputes ? responsibility may be assigned to a single executive – financial VP or executive VP
?
Administration of Transfer Prices
a committee can be set up to settle disputes, review sourcing changes and change transfer price rules when appropriate ? arbitration can be conducted by a formal system, where both parties submit a written case ? in less formal system, presentations may be largely oral ? irrespective of degree of formality of process, type of conflict resolution process will influence effectiveness of a transfer pricing system
?
Administration of Transfer Prices
there are four ways to resolve conflict: forcing, smoothing, bargaining and problem solving ? conflict resolution mechanisms range from conflict avoidance through forcing and smoothing to conflict resolution through bargaining and problem solving • Product Classification: ? extent and formality of sourcing and transfer pricing rules depend on number of intracompany transfers and availability of market and prices
?
Administration of Transfer Prices
some companies divide products into 2 classes: Class I: products for which senior management wants to control sourcing e.g. large volume ones Class II: all other products, that can be produced outside the company without any significant disruption to present operations e.g. small volume ? sourcing of class I products can be changed only with permission of central management, while, class II sourcing is determined by business units involved; both buying & selling units can freely deal either inside or outside the company
?
doc_936593921.ppt
This is a presentation that includes the entire basics of Transfer Pricing.
TRANSFER PRICING
Objectives of Transfer Prices
•
It should provide each business unit with relevant information needed to determine optimum trade-off between company costs and revenues • It should induce goal congruent decisions • It should help measure economic performance of individual business units • System should be simple to understand and easy to administer • If two or more profit centers are jointly responsible for product development, marketing and manufacturing, each should share in revenue
Transfer Pricing Methods
•
Transfer price is referred to the amount used in accounting for any transfer of goods and services between responsibility centers • One of the two parties involved is a profit center • Fundamental Principle: ? transfer price should be similar to price that would be charged if product were sold to outside customers or purchased from outside vendors ? Classical economics talks on selling prices equal to marginal costs and some authors advocate transfer price based on marginal cost
Transfer Pricing Methods
two decisions must be made periodically for profit centers to buy and sell products from one another: sourcing decision transfer price decision • Ideal Situation: ? competent people: Staff people involved in negotiation & arbitration ? good atmosphere: profit as significant consideration in performance
?
Transfer Pricing Methods
a market price: should reflect same conditions e.g. quantity, delivery time and quality Adjusted downwards to reflect savings to selling units from internal dealings e.g. no bad debts ? freedom to source: manager of each profit center has the right to deal with either insiders or outsiders at his or her will ? full information: Relevant alternatives and related costs & revenues
?
Transfer Pricing Methods
negotiation: a smooth working mechanism for contracts • Constraints on Sourcing: ? limited markets: existence of internal capacity might limit development of external sales if company is sole producer of a differentiated product, no outside source exists If a company has invested in facilities, outside sources will not be used unless selling price approaches company’s variable cost
?
Transfer Pricing Methods
competitive pricing, which can best satisfy profit center requirements, measures contribution of each profit center to total company profits ? Some ways to find competitive price are: ? based on published market prices ? set by bids ? for a production profit center selling similar products in outside market ? for a buying profit center purchasing similar products from outside market
Transfer Pricing Methods
excess or shortage of industry capacity: excess capacity – selling profit center cannot sell to outside market shortage of capacity – buying profit center cannot obtain product it requires from outside Even if no. of intracompany transfers is significant some senior management do not intervene on the theory that benefits of keeping profit centers independent offset loss from suboptimising company profits
?
Transfer Pricing Methods
Some companies allow either buying or selling profit center to appeal a sourcing decision to a central person or committee Given the option, buying profit center would prefer to deal with an outside source If the market price exists or can be approximated, use it In transfer pricing calculation, companies avoid advertising, financing & other expenses that seller does not incur in internal deal and same benefits pass on to the buyer also
Transfer Pricing Methods
•
Cost-based transfer prices: ? cost basis: standard costs should be used so that production inefficiencies are eliminated ? profit mark-up: base of mark-up and level of profit allowed base – % of costs v/s % of investment conceptual solution is to base profit allowance on investment ( at standard level), required to meet volume needed by buying profit centers
Transfer Pricing Methods
•
Upstream Fixed Costs and Profits: ? agreement among business units: Some companies establish a formal mechanism where representatives from buying & selling units meet periodically to decide on outside selling prices and sharing of profits for products with significant upstream fixed costs and profit This mechanism will work only when review process allows significant business to atleast one of the profit centers
Transfer Pricing Methods
two-step pricing: first, for each unit sold, a charge equal to standard variable cost of production is taken a periodic charge is made equal to fixed costs associated with facilities reserved for buying unit It would be appropriate under some circumstances to divide investment into variable (e.g. receivables and inventory) and fixed (e.g. plant) components Then a profit allowance based on return on variable assets would be added to standard variable cost for each unit sold
?
Transfer Pricing Methods
Following are some points about above method: ? monthly charge for fixed costs and profit should be negotiated periodically & will depend on capacity reserved for buying unit ? questions may be raised about accuracy of cost and investment allocation ? manufacturer’s unit profit allowance is not affected by sales volume of final unit ? conflict between interests of company and manufacturing unit ? this method is similar to “take or pay pricing”
Transfer Pricing Methods
profit sharing: this system can induce goal congruence between business unit and company interests here, product is transferred to marketing unit at standard variable cost after product is sold, business units share contribution earned, which is selling price minus variable manufacturing and marketing costs This method is useful if demand for manufactured product is not steady enough to warrant permanent assignment of facilities
?
Transfer Pricing Methods
this method has some practical problems: There can be arguments over contribution divided over two profit centers; this is costly and time-consuming for management to intervene Arbitrarily dividing up profits among units does not give valid information on unit’s profitability Since contribution is not allocated until sale is made, manufacturing unit’s contribution depends on marketing unit’s ability to sell as well as the actual selling price
Transfer Pricing Methods
two sets of prices: In this method, manufacturing unit’s revenue is credited at outside sales price and buying unit is charged total standard costs Difference is charged to a headquarters account and eliminated when business unit statements are consolidated This method is sometimes used when there are frequent conflicts between buying & selling units that cannot be resolved by one of other methods; both units benefit under such arrangement
?
Transfer Pricing Methods
There are some disadvantages to this method: Sum of business unit profits is greater than overall company profits This system creates an illusive feeling that business units are making money System might motivate business units to concentrate more on internal transfers There is additional bookkeeping involved Fact that conflicts would be reduced here can be taken as a weakness
Pricing Corporate Services
•
If these costs are charged at all, they are allocated and allocations do not include a profit component • There are mainly two types of transfers: ? for central services that receiving unit must accept but can atleast partially control amount used ? for central services that business unit can decide whether or not to use • Control over amount of service: ? business units can use company staffs for IT services and R & D, efficiency can’t be controlled
Pricing Corporate Services
one school of thought says that business unit should pay standard variable cost of discretionary services ? second school of thought advocates a price equal to standard variable cost plus a fair share of standard fixed costs – i.e. full cost ? third school advocates a price that is equivalent to market price or to standard full cost plus a profit margin • Optional use of services: ? often used for IT, maintenance, consulting groups and maintenance work.
?
Pricing Corporate Services
in some cases, management may decide that business units can choose whether to use central service units ? business units may procure service from outside, develop their own capability or choose not to use the service at all • Simplicity of pricing mechanism: ? prices charged for corporate services needs straight methods to be calculated ? computer experts are used as they already solve complex equations
?
Administration of Transfer Prices
•
Negotiation: ? in most companies, transfer prices are decided by business units on negotiated basis ? also, many transfer prices require a degree of subjective judgment. ? business unit usually have best information on markets and costs and consequently, are best able to arrive at reasonable prices. ? business unit must know ground rules for negotiation of transfer prices.
Administration of Transfer Prices
in some companies, headquarters inform units that they are free to deal with one another or with outsiders, subject to qualification that if there is a tie, business must be kept inside ? line managers should not spend time on transfer price negotiations • Arbitration and Conflict Resolution: ? a procedure should be in place for arbitrating price disputes ? responsibility may be assigned to a single executive – financial VP or executive VP
?
Administration of Transfer Prices
a committee can be set up to settle disputes, review sourcing changes and change transfer price rules when appropriate ? arbitration can be conducted by a formal system, where both parties submit a written case ? in less formal system, presentations may be largely oral ? irrespective of degree of formality of process, type of conflict resolution process will influence effectiveness of a transfer pricing system
?
Administration of Transfer Prices
there are four ways to resolve conflict: forcing, smoothing, bargaining and problem solving ? conflict resolution mechanisms range from conflict avoidance through forcing and smoothing to conflict resolution through bargaining and problem solving • Product Classification: ? extent and formality of sourcing and transfer pricing rules depend on number of intracompany transfers and availability of market and prices
?
Administration of Transfer Prices
some companies divide products into 2 classes: Class I: products for which senior management wants to control sourcing e.g. large volume ones Class II: all other products, that can be produced outside the company without any significant disruption to present operations e.g. small volume ? sourcing of class I products can be changed only with permission of central management, while, class II sourcing is determined by business units involved; both buying & selling units can freely deal either inside or outside the company
?
doc_936593921.ppt