Transfer Pricing

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Contents Chapter 1: Introduction ...............................................................................................................1

1.1 Early Application of Transfer Pricing ................................................................................1

1.2 Purpose of transfer pricing .................................................................................................2

1.3 Limitation of Transfer Pricing ...........................................................................................3

1.4 Relevant Concepts to Understand Transfer Pricing ............................................................4

1.5 Some Basic Issues on Transfer Pricing ..............................................................................5

1.6 A General Rule for Transfer Pricing ..................................................................................5

1.7 Factors that affect Transfer Price .......................................................................................7

1.8 Possible Methods of Transfer Pricing ................................................................................7

1.9 Internal Transfer Price Illustrated ......................................................................................8

Chapter 2: Literature review ........................................................................................................9

Chapter 3: Methods of Transfer Pricing ..................................................................................... 12

3.1 Market Based Transfer Prices .......................................................................................... 12

3.1.1 Advantage of Market Based Transfer Price ............................................................... 13

3.1.2 Limitations of Market Based Transfer Price .............................................................. 13

3.2 Cost-Based Transfer Pricing ............................................................................................ 14

3.2.1 Limitation of Cost-Based Transfer Price ................................................................... 14

3.3 Negotiated Transfer Pricing ............................................................................................. 15

3.3.1Limitations of Negotiated Transfer Pricing ................................................................ 16

3.4 Administered Transfer Pricing ......................................................................................... 17

3.5 Summary of Transfer Pricing Approaches ....................................................................... 17

3.6 Transfer Prices Based on Equity Considerations .............................................................. 17

Chapter 4: Multinational Transfer Pricing ................................................................................. 19

4.1 Illustration to understand the Tax Haven and Multinational Transfer Price ...................... 21

Chapter 5: Optimum Transfer Pricing ........................................................................................ 22

5.1 Minimum Transfer Price .................................................................................................. 22

5.2 Maximum Transfer Price ................................................................................................. 22

5.3 Idle Capacity and Transfer Price ...................................................................................... 23

5.4 No Idle Capacity and Transfer Price ................................................................................ 23

5.5 Some Idle Capacity and Transfer Price ............................................................................ 24

Chapter 6: Transfer Pricing Theory ........................................................................................... 25

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6.1 Economic Theory ............................................................................................................ 25

6.1.1 Assumptions of Economic Analysis .......................................................................... 25

6.1.2 Perfect Competition .................................................................................................. 26

6.1.3 Imperfect Competition .............................................................................................. 27

6.1.4 Graphical Presentation .............................................................................................. 27

6.1.4 Limitations of Economic Theories ............................................................................ 29

6.2 Accounting Theory .......................................................................................................... 30

6.2.1 Mathematical Programming ...................................................................................... 30

6.2.2 Dual Prices ............................................................................................................... 30

Chapter 7: Legal Aspects of Transfer Pricing ............................................................................ 32

Chapter 8: Transfer Pricing and Life Cycle ............................................................................... 37

Chapter 9: Mathematical Problems and Solutions ...................................................................... 39

Problem 1: ............................................................................................................................. 39

Problem 2: ............................................................................................................................. 40

Problem 3: ............................................................................................................................. 41

Problem 4: ............................................................................................................................. 43

Problem 5: (Multinational Transfer Pricing) .......................................................................... 43

Conclusions .............................................................................................................................. 44

References ................................................................................................................................ iv

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Chapter 1: Introduction Transfer prices are the price charged by one division of a company for goods or services provided

to another division of the same company. Transfer pricing involves the policies that companies set

for these intersegment transfers, the prices for the transfers, and the administration of the transfer

pricing policy. The major focus of transfer pricing in managerial accounting is the transfer of goods

or services from one investment or profit center to another investment or profit center within a

decentralized company.

Today, many companies are giant conglomerates having multiple divisions. Simply transferring

goods or services at cost no longer serves the need of these decentralized organizations. The

divisions within the same company are evaluated based on their profit, ROI and residual income.

And transfer pricing has the ability to manipulate the figure of the evaluation measurement of

respective divisions. To the division selling goods and services, the transfer price is its revenue.

To the division buying goods and services, the transfer price is its cost. Therefore, transfer prices

have a direct bearing on segment margin. Thus a major conflict occurs between divisions when

one division sell products or services to another segment.

Consider a general case where one division of a company manufactures a component that is used

by another division of the same company to produce a final product that is sold externally to the

company. Also assume that the two divisions are treated as independent investment centers and

that measures of income are used when evaluating these divisions. Thus, price that the

manufacturing division charges the buying division for the component will affect accounting

income of each division. From a corporate perspective, how-ever, the profit in any final product is

the price that product sold externally to the firm less the cost to manufacture it. While the profit

for each divisions is charges if one division pays another divisions more or less money for a part

of final product, the profit to the overall company remains unchanged since out-of-pocket costs

are unchanged. Thus, transfer pricing involves the allocation of the overall corporate profit on a

product to each of the divisions.

1.1 Early Application of Transfer Pricing

Early applications of transfer pricing were designed to facilitate the evaluation of unit

performance. General motors was one of the first and most energetic proponent of using transfer

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pricing to evaluate unit performance. The attitude reflected the history of transfer pricing General

Motors, a company built by acquiring independent companies. The objective if evaluating unit

performance and transfer pricing was to allow these formerly independent companies to maintain

their identities and their competitive edge- to allow them to operate and to be evaluated as if they

were independent organizations.

Alfred Sloan and Donaldson Brown, the senior managers of General Motors in the 1920s

understood well the importance of transfer pricing in this role:

The question of pricing product form one division to another is of great importance.

Unless a true competitive situation is preserved, as to prices, there is no basis upon which the

performance of the divisions can be measured. No division is required absolutely to purchase

product from another division. In their interrelation they are encouraged to deal just as they would

with outsiders. The independent purchaser buying products from any of our divisions is assured

that prices to it are exactly in line with prices charged our own car divisions. Where there are no

substantial sales outside, such as would establish a competitive basis, the buying division

determines the competitive picture- at times partial requirements are actually purchased from

outside sources so as to perfect competitive situation.

1.2 Purpose of transfer pricing The purposed of transfer pricing are as follow:

1. Divisional Performance Evaluation: The principal reason behind using transfer price is

that the manager wants to create performance metrics that ensure that managers who make

decisions to improve their divisions performance also increase the performance of the

organization as a whole. Transfer pricing should guide managers to make the best possible

decisions regarding whether to buy or sell products and services inside or outside the total

organization. Divisional managers should involve in maximizing their division profit in an

optimum manner in the form of using appropriate transfer price. In other words, decisions

that increase a divisional profit also increase the profits of the entire company.

2. Preserve Divisional Autonomy: Another goal of transfer pricing is to preserve divisional

autonomy. The management could dictate how much of any product or services one

division transfers to another. However, if an organization has decided that decentralization,

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with its focus on autonomy of divisional managers, is desirable, then divisional managers

must be free to make their own decisions.

Fig: Purpose of Transfer Pricing

1.3 Limitation of Transfer Pricing Transfer pricing serves two limitations which are related to conflicts. They are:

1. Price: They serves as a guide of local decision making. They help the producing division

decide how much to produce and the purchase division how much to acquire. There is a

potential for conflict whenever a number, such as divisional profit, that can be manipulated

or otherwise affected by managerial behavior is used to evaluate performance. The problem

is that when managers take actions to manipulate the performance measure, decision

making often suffers. If divisional managers are encouraged to maximize their individual

profits, they may take actions with respect with other division managers that cause overall

corporate profit to decline. For example, a purchaser may want source outside the company

from a supplier that is offering distress prices that cannot be sustained over the long term.

2. Subsequent Profit measurement by senior manager: Another limitation is subsequent

profit measurement of the divisions. The conflict between decision making and evaluation

of performance is the essence of the transfer pricing conundrum. A further conflict occurs

if managers emphasizes short term performance in their transfer price negotiations at the

expense of long run profitability of their division and the firm.

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1.4 Relevant Concepts to Understand Transfer Pricing To understand transfer pricing and applying transfer pricing certain concepts must be understood.

To successfully apply and administer transfer pricing, the following conditions must be fulfilled.

a. The company must be decentralized in nature. It means that the whole company is divided

into several divisions. Each division is responsible to report on their performance

individually which is known as segment reporting. This reporting is valid under the concept

of Responsibility accounting.

b. Divisions are individual in nature and independent.

c. Divisions are responsible for both cost and revenue individually. Thus the divisions must

be profit centers.

d. The senior managers will evaluate each division individually on the basis of divisional

contribution margin, ROI or residual income.

e. Corporate profit will be distributed to the divisions and transfer pricing will be treated as

the base for that.

Segment Reporting

Responsibility Centers (Cost & Profit)

Contribution Margin, ROI, Opportunity Cost , Relevant Cost etc.

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1.5 Some Basic Issues on Transfer Pricing In a decentralized company, managers of cost, profit and investment centers have varying degree

of autonomy to make critical decisions that effects their divisions. With complete

decentralizations, managers can decide whether to make a part within the segment, buy that part

form another divisions of the company, or buy it from an outside vendor. To achieve the most

profit for the company, that decision should include choosing a source of supply with the lowest

cost. Incremental costs to make a component within the division include both differential variable

and fixed costs. With external sources, incremental costs to the buying division consist of the

transfer price from another division or the price from an outside supplier.

From the buying divisions perspective, it is a make-or-buy decision where there is one source of

making and there are two sources of buying (another division or an outside company). From the

companys perspective, this make-or-buy decision has two sources of making (two different

divisions within the company) and one source of buying (the outside vendor). Because there is this

difference in perspective, managers of decentralized divisions may make decisions that seem

optimal for their divisions (income, ROI or RI go up) but not optimal for the overall company. It

is possible that transfer pricing policies, administration, and transfer prices will encourage

managers to choose, say, an outside vendor when, from a corporate-cost-stand point, the optimal

decision is to buy from another division.

1.6 A General Rule for Transfer Pricing Although no single rule always meets the goal of transfer pricing, a general rule can provide

guidance:

Transfer Price = Outlay Cost + Opportunity Cost

Outlay costs require a cash disbursement. They are essentially the additional amount the selling

division must pay to produce and transfer a product or service to another segment. They are often

the variable costs for producing the item transferred.

Opportunity cost is the maximum contribution to profit that the selling division forgoes by

transferring the item internally. For example if capacity constraints force a segment to either

transfer an item internally or sell it externally- that is, it cannot produce enough to do both- the

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opportunity cost for internal transfer is the contribution margin the division could have received

from the external sale.

To understand how this general rule works, an example can be illustrated. Consider two

hypothetical divisions. X division (the selling division) is considering transferring the fabric

required for a polo shirt to the Y division (the buying division).

Suppose the X divisions TK 4 opportunity cost arises because it can get TK 10 for the fabric on

the market. Thus, the contribution margin from selling on the market is TK 10 6 = TK 4. At any

transfer price less than TK 10, the division is better off selling the fabric on the market rather than

transferring it. Thus the minimum transfer price it would accept is TK 6 + (TK 10 TK 6) = TK

10.

Outside Supplier Price Decision by Division

manager

Decision Best for the

Company

Less than TK 10 Do not transfer- buying

division rejects transfer

because buying internally will

reduce profits?

Buy from outside supplier

because it is cheaper for the

company as a whole.

Greater than TK 10 If value to buying division is

greater than TK 10: transfer

at TK 10.

If value to buying division is

less than TK 10: Buying

division rejects transfer.

Transfer because internal

price is less than external

price.

Do not transfer because the

value of the fabric to the

company is less its cost.

Now consider how much the item is worth to the Division Y. For the fabric to be profitable to the

Y division, it must be able to sell the final product for more than the transfer price plus the other

costs it must incur to finish and sell the product. Because it can sell the Polo Shirt for TK 25 and

X Division

Outlay cost = Tk 6

Opportunity Cost= Tk 4

Transfer Price = TK 10

Y Division

Cost= TP+ other cost

=TK 10 + TK 12 = TK 22 Final Selling price= TK

25

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its other costs are TK 12, it would be willing to pay up to TK 25 TK 12 = TK 13 for it. But it

would not pay more to the X division than it would have to pay to the outsider for the equivalent

fabric. Thus the largest transfer price acceptable to the Y division is the lesser of i) TK 13 and ii)

the cost charged by an outside supplier.

1.7 Factors that affect Transfer Price Because of multiple goal of transfer pricing systems, the general rule, mentioned in above section,

does not produce an ideal transfer price. The factors that affect transfer price are mentioned below:

Variable Cost: Variable cost is used as a base for determining the transfer pricing.

Capacity and Idle Capacity: When the selling division does not have idle capacity to

produce product and supply to the internal division, the transfer price would equal to the

market price. Where idle capacity is available, the contribution margin lost is allocated to

all the product transferred to the internal division. In this case, the transfer price will be

less than the market price.

Ceiling and Floor: Market price is the ceiling and variable cost1 is the floor for any transfer

pricing mechanism.

1.8 Possible Methods of Transfer Pricing Followings are the possible methods for transfer pricing:

1 If it passes the Break Even Point, Then Fixed Cost becomes irrelevant.

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1.9 Internal Transfer Price Illustrated Hello.Com has two independent Divisions that produces Butter & Ghee respectively. Division-1

produces Butter which it can sale to outsiders at BDT 25 each. The variable cost per unit to

Division-1 is BDT 10 and fixed cost per unit is BDT 5 (It has already passed the Break Even point).

The Division-2s profit markup is 40%.

Q 1: What is the Market Based Transfer Price?

Q 2: What is the Minimum Transfer Price?

Q 3: What is the Cost plus Transfer price?

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Chapter 2: Literature review Just as prices facilitate transactions in external markets, internal transfer prices enable profit

centers to transact in internal markets. Eccles (1985) estimates that 80 percent of the Fortune 1,000

companies have internal transfer prices for goods. In an earlier survey, Vancil (1978) estimates

that on average the amount of goods traded internally is equivalent to 10 percent of total sales or

total cost of goods sold.

There is some disagreement between the economics and accounting literatures about which

activities and outcomes internal transfer prices should be designed to influence. The economics

literature proposes that transfer prices should be designed to lead autonomous profit centers to

make decisions that maximize firm profitsthat is, prices should lead centers to make decisions

that the firms executive managers would if they had full information. However, the accounting

literature adds a second goal for transfer pricesthey should aid, rather than impede, the

performance evaluation process for profit centers and their managers. To the extent that profit

centers are evaluated according to their return on investment and profit, transfer prices should be

designed so that they do not distort profits or costs across centers, giving false impressions of

performances and contributions to the corporation. Such distortions could lead center managers to

make suboptimal production or investment decisions. As is discussed below, the goals of profit

maximization and aiding performance evaluation can work against each other.

The transfer pricing goals of promoting optimal resource decisions and supporting performance

evaluation are short-run goals. Hirshleifer (p. 184) concludes his analysis with a cautionary note

about using transfer prices for strategic decisions: When non-marginal decisions like abandoning

a subsidiary are under consideration, a calculation of the incremental revenues and costs of the

operation as a whole to the firm should be undertaken.

There is a large body of research on optimal transfer prices that stems primarily from the

microeconomics and accounting literatures. There are several comprehensive reviews of this work

(see Eccles, 1985, and Eccles and White, 1988); therefore, we focus here on a few papers that

represent the range of transfer pricing research across disciplines.

Hirshleifer (1956) derives optimal transfer prices that lead autonomous profit centers to make

decisions that maximize firm profits. Assuming that the operating costs of each center are

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independent of the level of operations in other centers (technological independence) and that

additional external sales by a center do not reduce external demand for the other centers products

(demand independence), Hirshleifer demonstrates that the optimal transfer price is the marginal

cost of producing the intermediate good or service. More generally, the center that produces the

intermediate product should provide a schedule of marginal cost associated with different output

levels so that the center that produces the end product can choose the optimal joint level of output.

The only circumstance under which this optimal price equals the market price for the intermediate

product is when the external market for the product is perfectly competitive. Marginal cost transfer

prices provide the center that produces the end product with the information necessary to produce

at the level that is optimal for the firm as a wholethe level that equates the marginal cost of

production with marginal revenue.

Eccles interviewed 144 managers in 13 firms from the chemicals, electronics, heavy machinery,

and machinery components industries to determine how transfer prices are implemented and

managed in practice. Eccles (1985 and 1991) and Eccles and White (1988) discuss the three most

common transfer pricing policies observed in the survey: mandated full-cost transfers, mandated

market-based transfers, and exchange autonomy in which prices range between full cost and

market. In addition to observing diversity in policies across firms, the authors observed multiple

policies even within firms corresponding to different product strategies and environments. This

divergence between theory and practicein particular, a lack of marginal cost pricing and frequent

use of full-cost transfersled to a new theory to explain transfer pricing practices.

Eccles (1985) and Eccles and White (1988) emphasize that a firms transfer prices must be tailored

to support the firms strategy and policies. Further, prices must be flexible enough to adapt to

changes in these. Eccles and White link the three popular transfer pricing practices to two strategic

questions that any firm with an internal market must address. The first is whether the profit centers

are part of a strategy of vertical integration; that is, are internal transfers mandated or are

purchasing and selling centers allowed to make choices among potential internal and external

exchange partners that maximize their individual outcomes. If the firm has a strategy of vertical

integration, the second question is whether the firm is pursuing a strategy of vertical integration to

lower the costs of intermediate products. If so, Eccles survey indicates that the firm will

implement full-cost transfer prices.4 Otherwise, the firm will use market-based prices that

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facilitate comparisons of internal profit centers to external competitors. Eccles (1985) argues that

transfer prices based on variable costs are rarely seen in practice because they hinder measurement

and evaluation of profit center contributions to the company.

Kaplan and Atkinson (1989) also acknowledge the tension between the transfer pricing goals of

promoting economic decisions and enhancing performance evaluation and tie their

recommendations for optimal transfer pricing policies to firm strategies and environments. The

authors first three recommendations are quite similar to those discussed above. First, if a

competitive market exists for the intermediate product, Kaplan and Atkinson recommend that the

transfer price for the item should be set equal to the market price (less transaction costs that are

avoided with internal transfers). At the other extreme, if no external market exists for the

intermediate product, the transfer price that leads to the optimal level of internal transactions is the

marginal cost of production. The authors also advocate that the purchasing center should pay a

fixed fee to the selling center for the privilege of transacting with it at marginal cost. This fixed

fee would cover the selling centers fixed costs. By assigning fixed costs in proportion to the

percentage of capacity devoted to the internal purchaser, this two-part pricing scheme leads to

efficient resource allocation while allowing the selling division to recover its costs and forcing the

purchasing center to recognize the full cost of obtaining products from the selling center.5 When

an imperfectly competitive market exists for the intermediate product, Kaplan and Atkinson

recommend that the managers of the purchasing and selling centers negotiate the price and terms

of the transfer. This policys success requires freedom to buy and sell externally, occasional

transactions with external suppliers and buyers, and support from high-level management.

Kaplan and Atkinsons recommendations diverge from those of Eccles (1985 and 1991) and Eccles

and White (1988) with respect to full cost prices. While Kaplan and Atkinson note that such prices

are often used in practice, they find no justification for them. The authors argue that full-cost prices

distort economic decision making by transforming the fixed costs of the selling center into variable

costs for the purchasing center. These prices provide poor incentives for the selling center because

they do not reward efficiency or penalize inefficiency. Full-cost prices also do not contribute to

evaluating the performance of centers. And finally, inclusion of firm costs, such as G&A, that are

allocated across centers may make the firms end product less competitive (e.g., if the prices of

intermediate products include a proportional markup for profit).

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Chapter 3: Methods of Transfer Pricing There are two forms of transfer pricing. One form, which we call international transfer pricing,

addresses the prices organizations charge when they transfer products and services between related

organization entities that operate under different tax jurisdictions. The second form of transfer

pricing, which we call domestic transfer pricing. Domestic transfer pricing is the set of rules an

organization uses to allocate jointly earned revenue among responsibility centers. This chapter

only deals with domestic transfer pricing.

Under domestic transfer price, there are four approaches to transfer pricing:

3.1 Market Based Transfer Prices Market prices refer to the price that a selling division can get for its product in the external market

or the price at which a buying division can purchase the product in the market place. With some

intermediate goods there is an external market while with others there is not.

So, if the external market exist for the intermediate product or service, market based transfer prices

are the most appropriate basis for pricing the transferred goods or service between responsibility

centers. The market price provides an independent valuation of the transferred product or services

and how much each profit center has contributed to the total profit earned by the organization on

the transaction. For example, the selling division, instead of transferring the good internally, could

sell it externally. Similarly, the buying division could purchase externally rather than receiving

internal transfer.

Here, a buying division would rarely be willing to pay another division of the same company a

price that exceeds the market price. In fact, since there would be little or no selling expenses nor

Market Based Transfer Pricing

Cost-Based Transfer Pricing

Negotiated Transfer Pricing

Administered Transfer Pricing

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the possibility of an uncollected account receivable with an internal sale, selling division may

agree to a price that is less than the market price.

From the companys point of view, the market price is the opportunity cost when a selling division

is at full capacity. Sales at less than market price result in lost business that would have served if

transfers occur at market.

If there is a competitive market for the intermediate product or service being transferred internally,

using the market price will generally lead to goal congruence. Because the market price is equal

to the variable cost plus opportunity cost.

Transfer Price = Variable Cost + Opportunity Cost

= Variable Cost + (Market Price - Variable Cost)

= Variable Cost Variable Cost + Market Price

= Market Price

3.1.1 Advantage of Market Based Transfer Price The basic Advantage of using market based transfer price is that they allow each division to be

evaluated on a stand-alone basis. Measures of income have more validity when market prices are

used. Managers are encouraged to treat their divisions as independent companies and to buy from

whatever source seems the best under current market conditions.

3.1.2 Limitations of Market Based Transfer Price There are some limitations to the use of market prices.

First, a market may not exist for an intermediate product. Take the case of the transmission

division of an automobile company. There may be no external market to buy the transmissions that

the assembly division needs. In this case, divisions may approximate market by either basing

pricing on like product manufactured in the market or by marking up costs of production in the

same manner that they would for an outside sale.

Second, if a division is a captive of another division, then there is a real question about using

income-based measures to evaluate the division. A captive selling division that provides 100

percent of its output to another division may well be evaluated as a cost center. A captive buying

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divisions of the company may be evaluated as a revenue center. In this case there is dependence

between the divisions, and it would be best if they were evaluated together as a single unit.

Finally, there are some market-based transfer prices that can lead to suboptimal decision.

3.2 Cost-Based Transfer Pricing When market prices dont exist, most companies resort to cost-based transfer pricing. However

there are many possible definition of cost. Some companies use only variable cost, others use full

cost, and still others use full cost plus markup. Some use standard cost and some use actual cost.

For example, consider a product that has a variable manufacturing cost of $5.00 and allocated fixed

manufacturing cost of $3.00. Suppose that the target markup is 10%. The different possible cost-

based transfer prices are as follows:

Variable Cost $5.00

Variable Cost Plus Markup $5.50

Full Cost $8.00

Full Cost Plus Markup $8.80

Other approaches under cost based transfer prices may be:

a. Marginal Cost Transfer Prices

b. Activity Based Costs for Transfer Pricing

3.2.1 Limitation of Cost-Based Transfer Price

Although the cost approach to setting transfer prices is relatively simple to apply, it has some major

defects.

The use of cost- particularly full cost- as a transfer price can lead to bad decisions and thus

sub optimization. As the cost approach assumes that the selling division has enough idle

capacity, it does not consider the opportunity cost of lost contribution margin from

outsiders. This assumption may not hold true for the selling division causing a substantial

loss which may also reduce the profit of the company as a whole.

If cost id used as the transfer price, the selling division will never show a profit on any

internal transfer. The only division that shows a profit will be the division that makes the

final sale to an outside party.

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Cost based transfer prices do not provide incentives to control costs. If the actual costs of

one division are simply passed on to the next, there is little incentive for anyone to work to

reduce it. This problem can be overcome by using standard costs rather than actual cost

transfer prices.

3.3 Negotiated Transfer Pricing A negotiated transfer price results from discussion between the selling and buying divisions. The

negotiating process typically begins when the production division provides a price quotation plus

all relevant delivery conditions. The purchasing division may

1. Accept the deal

2. Bargain to obtain a lower price or better conditions

3. Obtain outside bids and negotiate with external suppliers.

4. Reject the bid and either purchase outside or not purchase at all.

In different sequence, the purchasing division may make an offer to the producing division for a

portion of its current output or an increment to current output. The production division then bargain

with the purchasing division over terms, talk to its existing customers, or decide not to accept the

purchasing divisions offer.

Negotiated transfer price from sellers perspective:

+

Negotiated Transfer price from Buyers perspective:

Thus the range of negotiated transfer price is:

+

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The following Figure exhibits the overall considerations of negotiated transfer price.

In order to have an effective and efficient system of intra company transfer pricing, the following

issues should be kept in mind.

3.3.1Limitations of Negotiated Transfer Pricing It is time-consuming for the managers involved

It leads to conflict between divisions

It makes the measurement of profitability sensitive to the negotiating skills of managers

It requires the time of top management to oversee the negotiating process and to mediate

disputes

It may lead to a suboptimal level of output if the negotiated price is above the opportunity

cost of supplying the transferred goods.

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3.4 Administered Transfer Pricing An arbitrator or a manager who applies some policy sets administered transfer prices, for example,

market price less 10% or full cost plus 5%. Organizations often use administered transfer prices

when a particular transaction occurs frequently. However, such prices reflect neither pure

economic considerations, as negotiated transfer prices do.

3.5 Summary of Transfer Pricing Approaches Table no. summarizes the four major approaches of transfer pricing.

Advantage Problems

Market Based If a market price exists, it is objective and provides the proper economic incentives.

There may be no market or may be difficult to identify proper market price.

Cost Based This is easy to put in place because cost measures are often available in the accounting system.

There are many cost possibilities but any cost other than the marginal cost will not provide proper economic signal.

Negotiated This reflects the accountability and controllability principles underlying responsibility centers.

This can lead to decisions that do not provide the greatest economic benefit.

Administered This is simple to use and avoids confrontations between the two parties to the TP relationships.

This trends to violate the spirit of the responsibility approach.

3.6 Transfer Prices Based on Equity Considerations Administered transfer prices are usually based on cost; that is, the transfer price is cost plus some

markup on cost or market. Thus, transfer price is some function. Such as 80% of the market price.

However sometimes administered transfer prices are based on equity considerations that are

designed around some definition of what constitutes a reasonable division of a jointly earned

revenue or a jointly incurred cost.

For example, consider the situation in which three responsibility center managers need warehouse

space. Each manager has undertaken a study to determine the cost for an individual warehouse that

meets the responsibility centers needs. The costs are as follows: manager A- $3 million, manager

B- $6 million and manager C- $5 million. A developer has proposed that the managers combine

their needs into a single large warehouse, which could cost $11 million. This represent a $3 million

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savings from the total cost of $14 million if each manager were to build a separate warehouse. The

issue is how the manager should split the cost of the warehouse.

One alternative, sometimes called the relative cost method, is for each manager to bear a share of

warehouse cost that is proportional to that managers alternative opportunity. The cost allocation

may be:

Manager As Share = $11,000,000 * $3,000,000/$14,000,000 = $2,357,143

Manager Bs Share = $11,000,000 * $6,000,000/$14,000,000 = $4,714,286

Manager Cs Share = $11,000,000 * $5,000,000/$14,000,000 = $3,928,571

This process is fair in the sense of being symmetrical. All parties are treated equally, and each

allocation reflects what each individual faces. Another approach, which reflects the equity criterion

of ability to pay, is to base the allocation of cost on the profits that each manager derives from

using warehouse. Still another approach, which reflects the equity criterion of equal division, is to

assign each manager a one third share of the warehouse cost.

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Chapter 4: Multinational Transfer Pricing In today's global markets, companies may produce goods and services domestically and sell them

internationally or produce them outside the country and sell them here. Since the profit is earned

in the country of the sale, differences in tax laws can be the leading determinant of transfer pricing

choices. Tax factors include not only income taxes but also payroll taxes, custom duties, tariffs,

sales taxes, environment related taxes and other government levies on organizations. Lax tax laws

in one country can encourage a Multi-National Corporation to deploy resources in that country.

Choice of an appropriate transfer pricing policy can help in minimizing a company's tax burden,

foreign exchange risks and can lead to better competitive position and governmental relations.

Although domestic objectives such as divisional autonomy and managerial motivation are always

important, they often become secondary when international transfers are involved. Companies

would typically focus on charging a transfer price that would reduce its tax bill or that will

strengthen a foreign subsidiary.

For example, a company may choose a low transfer price for parts shipped to a foreign subsidiary

to reduce custom duty payments or to help the subsidiary to compete in foreign markets by keeping

the subsidiarys costs low. On the other hand, it may choose to charge a higher transfer price to

draw profits out of a country that has high income tax rates to a country that has lower tax rates or

out of a country that has stringent control on foreign remittances.

Transfer pricing is a major concern for multinational companies as highlighted by the fact that

approximately 80% of Fortune 1000 firms select transfer pricing policies keeping financial, legal

and other operational considerations in mind. In addition, intra-firm trade accounts for about 55%

of the trade between Japan and EU, and 80% of the trade between US and Japan.

Tax authorities are aware of the incentives to set transfer prices to minimize taxes and import

duties. Therefore, U.S. Internal Revenue Service (IRS) pays close attention to taxes paid by

multinational companies within their boundaries. At the heart of the issue are the transfer prices

that companies use to transfer products from one country to another. For example, in 2004, the

IRS fined U.K. based pharmaceutical manufacturer GlaxoSmithKline $5.5 billion in back taxes

and interest, stemming from a transfer pricing dispute regarding profits from 1989 through 1996.

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Fig: Aspects of Multinational Transfer Pricing

Suppose a division in a high-income-tax-rate country produces a subcomponent for another

division in a low-income-tax-rate country. By setting a lower transfer price, the company can

recognize most of the profit from the production in the low-income-tax-rate country, thereby

minimizing taxes. Likewise, items produced by divisions in a low income tax rate country and

transferred to a division in a high income tax rate country should have a high transfer price to

minimize taxes. Sometimes import duties offset income tax effects. Most countries base import

duties on the price paid for an item, whether bought from an outside company or transferred from

another division. Therefore, low transfer prices generally lead to low import duties.

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4.1 Illustration to understand the Tax Haven and Multinational Transfer

Price Consider a high end running shoe produced by an Irish Nike division with a 12% income tax rate

and transferred to a division in Germany with a 40% rate. In addition, suppose Germany imposes

an import duty equal to 20% of the price of the item and that Nike cannot deduct thus import duty

for tax purpose. The full unit cost of a pair of the shoes is $100 and the variable cost is $60. If the

tax authority allow either variable or full cost transfer prices, which should Nike choose? By

transferring at $100 rather than at $60, the company may gain:

Effect of Transferring at $100 instead of at $60 $

Income of the Irish division is $40 higher;

It pays 12%*$40 more income tax

($4.80)

Income of German division is $40 lower

It pays 40%*$40 less income tax

16.00

Import duty on additional $40

It pays 20%*$40 more duty

(8.00)

Net savings $3.20

The net savings from transferring at $100 instead of $60 is $3.20 per unit. Companies may also

use transfer pricing to avoid financial restrictions imposed by some governments. For example, a

country might restrict the amount of dividends paid to foreign owners. It may be easier for a

company to get cash from a foreign divisions as payment for items transferred than as cash

dividends.

In summary, transfer pricing is more complex in multinational company than it is in a domestic

company. Multinational companies try to achieve more objectives through transfer-pricing

policies, and some of the objectives can conflict with one another.

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Chapter 5: Optimum Transfer Pricing Although no general rule always meets the goal of choosing the best transfer pricing policy, some

guidelines and boundaries can be established:

5.1 Minimum Transfer Price The minimum transfer price acceptable to the selling division is clearly the variable unit cost of

the product. Since, fixed costs are considered to be sunk costs, selling division would be interested

in trading as long as its out of pocket costs are covered.

This is true, however, if the selling division has sufficient capacity to produce the entire order and

would not have to give up some of its regular sales. In cases where capacity constraints force the

division to either transfer an item internally or sell it externally- that is, it cannot produce enough

to do both, then the selling division would expect to be compensated for the contribution margin

on those lost sales. In general, if the transfer has no effect on fixed costs, then from the selling

divisions standpoint, the transfer price must cover both the variable cost of producing the

transferred units and any opportunity costs from lost sales.

From the firms standpoint, transfer is desirable if (1) the total cost of producing the good (by both

divisions) is less than the price it can receive for the good in the outside market and (2) it does not

pay more to produce the good internally than it would have to pay to buy it in the marketplace.

The only transfer price that would achieve both these objectives for the firm is the formula

suggested below:

Minimum Transfer Price =Sellers variable cost +opportunity cost.

5.2 Maximum Transfer Price

From the buying divisions perspective, the trade is beneficial only if its profit increases. For that,

it must be able to sell the final product for more than the transfer price plus other costs incurred to

finish and sell the product. So the maximum transfer price that it can offer is the difference between

the final price and additional variable costs incurred by the buying division. This transfers the

entire surplus from the transaction to the selling division. For example, if a good can be sold in the

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market for $30 and the variable costs of selling and buying division are $10 and $6 respectively,

then the buying division can pay up to $24 ($30 - $6). Anything more would put him at a loss.

In cases where the buying division has an outside supplier available, the choice of maximum

transfer price is simple. Buy from an inside supplier only if the price is less than the price offered

by the outside supplier. This may lead to suboptimal decision from the firms standpoint. For

example, if a good can be sold in the market for $30 and the variable costs of selling and buying

division are $10 and $6 respectively, then per unit profit for the company is $14. However, if the

transfer price is set at $12 and an outside supplier is willing to provide it for $11, the buying

division would buy it from outside, even though the company could have spent only $10 in

producing it internally. So, the highest transfer price in this case is $11, the alternative maximum

price from an outside source.

5.3 Idle Capacity and Transfer Price

As mentioned before, idle capacity can significantly change the economics and psychology of

transfer pricing. If selling division has large unused capacity, more than enough to satisfy the

buying divisions demand, then it would be interested in the proposal as long as its variable cost

is covered. Since there would be no lost sales, there is no opportunity cost, minimum transfer price

would be equal to variable cost. ($10 in the example above.)

Maximum transfer price would, once again, depend on the availability of an outside price. If the

buying division can buy similar product from an outside vendor for $15, then it would be unwilling

to pay more than $15 as the transfer price.

Thus combining the requirements of both the selling and the buying division, the acceptable range

of transfer price would be between $10 and $15.

5.4 No Idle Capacity and Transfer Price

Generally, firms prefer internal transactions to external ones. After all, firms are organized as a

collection of profit centers due to synergies and savings in transaction, bargaining, marketing and

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other administrative costs and would prefer to produce a part internally than buy it from outside.

Other reasons for firms to prefer an internal transaction may be quality control, timely delivery

and security of proprietary information. So if the selling division is selling its entire capacity

production to outside market, it would have to divert some product away from its regular customers

to be able to fill an order from the buying division.

In such cases, the minimum transfer price would be unit variable cost plus the unit contribution

margin from lost sales. To continue the example above, suppose that the selling division is selling

its entire capacity of 1000 units to outside market at $15 per unit and receives an order of 200 units

to be supplied to the internal division. So the minimum price, that the selling division is willing

to consider as transfer price, is its unit variable cost ($10) plus the unit contribution margin on lost

sales ($5 = $15 - $10).

The maximum transfer price, as before, would be equal to the cost of buying it from an outside

supplier. Thus, if the outside vendor is ready to supply the good at $18 as in the example above,

the transfer price would be set between a range of $15 and $18.

5.5 Some Idle Capacity and Transfer Price

If the selling division has only some idle capacity, but not enough to fill the entire order by the

buying division, then it would have to divert only some of the product from its regular customers,

keeping the opportunity cost portion of the minimum transfer price at a lower level. In our example,

suppose the selling division is currently selling only 900 units when its capacity is 1000 units, it

can supply only 100 units internally without diverting sales from its regular customers. However,

the buying division needs 200 units. Let us also assume that the selling division will have to supply

the entire order of 200 units, having to divert 100 units from its regular customers. Thus the

minimum transfer price would be variable cost ($10 x 200 units = $2000) plus the unit contribution

margin on lost sales ($5 x 100 units=$500). Since the transfer quantity is 200 units, unit transfer

price would be $12.50 = ($2000 + $500)/ 200 units.

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Chapter 6: Transfer Pricing Theory There seems to be a gap between the theory of transfer pricing and its practice. Keegan and

Howard, after surveying the practices of 74 of the largest industrial companies in the US,

concluded that the only viable transfer price is market-based. They believe that cost-based transfer

prices are fine for class room discussion and an accounting exercise, but market based prices are

called for when a company adopts a decentralized strategy. On the other hand, Eccles interviewed

144 managers at 13 companies and concluded that transfer prices should be based on full costs

when selling profit center is not viewed as a distinct business for both internal and external sales.

In order to understand this conflict, we will review the basic academic theories, their strengths and

their weakness.

6.1 Economic Theory Early attempts to set transfer pricing policy were based on marginal prices and marginal costs.

Basic economic analysis involves the point where marginal cost equal marginal revenue. The

conclusion of this theory is that market prices are ideal transfer prices when:

1) There is perfect competition for the intermediate product or

2) The selling division is operating at a full capacity

Only under these two conditions will buying and selling divisions make goal-congruent decisions

using market based prices.

6.1.1 Assumptions of Economic Analysis

In economic theory of TP, it is assumed that:

Two profit centers. These are independent both in demand and technology;

If divisions compete for the same scarce resources, this would not be true;

An intermediate market exists

If the divisions are not independent, it gives rise to a question whether the divisions should be

treated as a separate profit centers.

The economic theory will be discussed under two market conditions namely,

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6.1.2 Perfect Competition From an economists point of view, perfect competition means that the selling division can sell all

it wants to of a product at the same price. Once a price is set, it will not change no matter how

many units of product are sold. Thus, marginal revenue for the selling division equals the external

market price. The selling division will maximize its profits when its marginal cost equals the

outside market price. This output level may or may not be at capacity, depending on the marginal

cost structure of the division.

From the companys perspective, the opportunity cost of any unit of intermediate product, given

the output level chosen by selling division, would be the market price of that product. This is true

since the selling division could sell all its output on the external market at that same price.

On the other hand, buying division will choose an output level at which its marginal revenue is

equal to its marginal cost. If the buying division uses fewer intermediate products than the selling

divisions makes, excess will be sold to the external market. If the buying division needs more unit

than the selling division is producing, the buying division can go for external purchase.

Say for example,

X (Buying Division)

Demand

Y (Selling

Division)

Supply

Decision of Divisions

1000 1500 Y will sell excess 500 unit to external market

1800 1500 X will purchase 300 unit from external market

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6.1.3 Imperfect Competition With imperfect competition, a selling division cannot sell all it wants to at a fixed price. As quantity

goes up, price goes down. The law of demand is applied here. Optimal output for the selling

division is again found at the point where marginal cost equals marginal revenue. Since marginal

cost for the buying division increases as the transfer price rises, the higher price that the selling

division charges, the lower the amount that will be made of the final product. Looking at the profit

for the overall company, however, the output choice of the buying division may not be optimal.

Here, as the transfer price increases the marginal cost for the buying division will also increase.

As the marginal cost of the buying division increases, the demand for the final product in the

market will decrease as higher the price will result in lower quantity demanded. For this reason,

charging higher transfer price by the selling division causes the buying division produce lower

amount of final product. Thus, output choice of the buying division may not be optimum.

6.1.4 Graphical Presentation Where no External Market Exists

From marginal price determination

theory, the optimum level of output is that

where marginal cost equals marginal

revenue. That is to say, a firm should

expand its output as long as the marginal

revenue from additional sales is greater

than their marginal costs. In the diagram

that follows, this intersection is

represented by point A, which will yield

a price of P*, given the demand at point

B.

When a firm is selling some of its product to itself, and only to itself (i.e. there is no external

market for that particular transfer good), then the picture gets more complicated, but the outcome

remains the same. The demand curve remains the same. The optimum price and quantity remain

the same. But marginal cost of production can be separated from the firm's total marginal costs.

Likewise, the marginal revenue associated with the production division can be separated from the

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marginal revenue for the total firm. This is referred to as the Net Marginal Revenue in production

(NMR) and is calculated as the marginal revenue from the firm minus the marginal costs of

distribution.

Where Competitive External Market Exists

If the production division is able to sell the

transfer good in a competitive market (as

well as internally), then again both must

operate where their marginal costs equal

their marginal revenue, for profit

maximization. Because the external

market is competitive, the firm is a price

taker and must accept the transfer price

determined by market forces (their

marginal revenue from transfer and

demand for transfer products becomes the

transfer price). If the market price is

relatively high (as in Ptr1 in the next

diagram), then the firm will experience an internal surplus (excess internal supply) equal to the

amount Qt1 minus Qt2. The actual marginal cost curve is defined by points A, C, D.

Where an Imperfect External Market Exists

If the firm is able to sell its

transfer goods in an imperfect

market, then it need not be a price

taker. There are two markets each

with its own price (Pf and Pt in

the next diagram). The aggregate

market is constructed from the

first two. That is, point C is a

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horizontal summation of points A and B (and likewise for all other points on the Net Marginal

Revenue curve (NMRa)). The total optimum quantity (Q) is the sum of Qf plus Qt.

6.1.4 Limitations of Economic Theories

The limitations of economic theories are:

1. It is Doubtful that managers have the ability to determine the marginal price under existing

accounting and information systems.

2. Marginal Costs can ignore fixed costs as sunk cost

3. It is assumed that managers of divisions may involve in gaming and misinformation so that

divisional profit can be increased

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6.2 Accounting Theory Accounting theory is based on the notion of opportunity cost to the firm and the interrelationship

between transfer pricing and divisional performance evaluation. From the opportunity cost

perspective, the basic premise is that standard variable cost is the lowest transfer price and is the

base when excess capacity exists. Market price is the opportunity cost at full capacity.

If there is no external market for the intermediate product, the opportunity cost when at full

capacity is the standard variable cost of the component plus the contribution margin that would be

made on goods that must be limited if the transfer takes place. Linear programming can help with

this estimate since shadow prices show lost contribution margins for constrained resources.

Some approaches under accounting theory are discussed below:

6.2.1 Mathematical Programming Mathematical programming has been suggested as a way to solve the transfer-pricing problem.

The objective is to maximize corporate profits. Divisions inform central management about costs,

resource use, and resource availability as well as revenue from outside sales. A linear program is

run that yields the optimum transfers of components between division and external sales of

components and final goods. In addition, transfer prices are set by the model.

Mathematical programming is criticized for the following reasons:

Since the process relies on accurate information, managers have the opportunity to

manipulate the information.

With such a centralized notion of quantities and transfer prices, decentralization becomes

limited.

6.2.2 Dual Prices If the selling divisions were allowed to show revenue based on market prices while the buying

divisions were to show cost based on standard variable cost plus incremental fixed costs, both

divisions incomes would be maximized and the transfer could take place. This process is called

dual pricing. Since profit for the overall company are not affected given any transfer price that is

charged, it is a simple matter to use dual prices and to eliminate their effects during consolidation

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of accounting records for corporate reporting. However, managers may not like a system that

reflects different values for the two divisions.

Say, Division A incurs variable cost TK 5 to start the product and Division B incurs TK 3 to

complete the product which is sold at TK 20. Then, the transfer price charged to division B from

division A is TK 5. The price received by division A is TK 17. Different price is recorded in

different account.

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Chapter 7: Legal Aspects of Transfer Pricing In Bangladesh there is a transfer pricing regulation. It is named as Bangladesh Transfer Pricing

Regulations- Finance Act 2014. It has been effective from 1st July 2014 by Finance Act 2014.

These regulations were originally introduced in 2012.

The National Board of Revenue (NBR) is the taxing authority and the tax laws have been

introduced as:

Section 107A to 107J of the Income Tax Ordinance, 1984 (the Ordinance)

Rule 70 to 75A of the Income Tax Rules, 1984 (the Rule)

This Alert outlines the provisions in these tax laws.

Associated Enterprise Section 107(A)(2)

The pricing of any income or expense arising from international transactions between associated

enterprises will need to be determined with regard to the arms length principle, using methods

prescribed under Bangladesh transfer pricing legislation.

According to Section 107(A)(2), an associated enterprise is an enterprise that at any time during

the income year has any one of the following relationship with the other enterprise:

(a) One enterprise participates directly or indirectly or through one or more intermediaries in the

management or control or capital of the other enterprise

(b) Same person or persons participates directly or indirectly or through one or more intermediaries

in the management or control or capital of both enterprises

(c) One enterprise holds directly or indirectly shares carrying more than 25% of the voting power

in the other enterprise

(d) Same person or persons controls shares carrying more than 25% of the voting power in both

enterprises

(e) The cumulative borrowings of one enterprise from other enterprise exceeds 50% of the book

value of total assets of that other enterprise

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(f) The cumulative guarantees provided by one enterprise in favor of the other enterprise exceeds

10% of the book value of total borrowings of that other enterprise

(g) More than half of the board of directors or members of the governing board of one enterprise

are appointed by the other enterprise

(h) Any executive director or executive members of the governing board of one enterprise is

appointed by or is in common with the other enterprise

(i) Same person or persons appoint more than half of the board of directors or members in both

enterprises

(j) Same person or persons appoint any executive director or executive members in both enterprises

(k) One enterprise has the practical ability to control the decision of the other enterprise

(l) The two enterprises are bounded by such relationship of mutual interest as may be prescribed

International Transaction Section 107(A)(5)

Transfer pricing provisions are applicable to the following types of international transactions

between associated enterprises, at least one of them being a nonresident:

Purchase, sale or lease of tangible or intangible property

Provision of services

Lending or borrowing money

A mutual agreement or arrangement for cost allocation or apportionment in connection

with a benefit, service or facility provided or to be provided

Any other transaction having a bearing on the profits, income, losses, assets, financial

position or economic value of such enterprises

If an enterprise enters into a transaction with a third party, where there is a prior agreement between

the third party and the associated enterprise, or if the terms of the relevant transaction are

determined in substance between the third party and the associated enterprise, then such

transactions shall be deemed to be an international transaction.

Enterprise means a person or a venture of any nature and also includes a permanent establishment

of such person or venture.

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Methods for computation of Arms Length Price Section 107(C)

Bangladesh transfer pricing legislation prescribes the following methods for the determination of

arms length price:

Comparable Uncontrolled Price Method (CUP)

Resale Price Method (RPM)

Cost Plus Method (CPM)

Profit Split Method (PSM)

Transactional Net Margin Method (TNMM)

Any other method

Where it can be demonstrated that none of the first five methods can be reasonably applied to

determine the arms length price for an international transaction, Section 107C allows the use of

any other method that can yield a result consistent with the arms length price.

For the purpose of determining a comparable uncontrolled transaction, Rule 71(3) provides that

data relating to the relevant financial year should be considered. However, the proviso to the Rule

permits the use of data relating to the period prior to the relevant financial year if it can be

substantiated that such data bears such facts that could have an influence on the analysis of

comparability.

As per the proviso to section 107C, transfer pricing provisions shall not apply if it results in

lowering the total income computed by virtue of complying with the arms length principle.

The Bangladesh transfer pricing provisions do not provide any tolerance band when determining

the arms length price for benchmarking international transactions.

Documentation requirements as per Rule 73

A detailed list of the documentation requirements are listed in Rule 73. Some of the key

documentation requirements are:

Profile of the multinational group including the consolidated financial statements of the

group

Profile of each member of the group including business relationships between each

member

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Profile of each associate enterprise including tax registration numbers and financial

statements of any

associated enterprise operating in Bangladesh

Business description

The nature and terms (including prices) of international transactions

Description of functions performed, risks assumed and assets employed

Record of any financial estimates

Record of uncontrolled transaction with third parties and a comparability evaluation

Description of methods considered

Reasons for rejection of alternative methods

Details of transfer pricing adjustments

Any other information or data relating to the associated enterprise which may be relevant

for determination of the arms length price

As per Rule 73, the abovementioned information and documents shall be kept and maintained for

a period of eight years from the end of the relevant assessment year.

The above documentation requirements shall not be applicable in case of an assessee where the

aggregate value of international transactions entered into during an income year, as recorded in the

books of accounts does not exceed Taka 30,000,000 (approx. US$ 390,000).

Statement of international transactions Section 107(EE)

The Finance Act, 2014 has inserted a new section 107EE by virtue of which every person who has

entered into an international transaction shall furnish, along with the return of income, a statement

of international transactions in the form and manner as prescribed under Rule 75A.

Accountants report Section 107(F)

Under Section 107F, every person who has entered into an international transaction or transactions

the aggregate value of which exceeds Taka 30,000,000 (approx. US$ 390,000) during an income

year shall furnish, on or before the specified date, in the form and manner as prescribed under Rule

75, a report from a Chartered Accountant.

Transfer pricing penalties Section 107(G), 107(H), 107(I)

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For failure to keep, maintain or furnish any information or documents or records as required by

Section 107E, the tax officer may impose a penalty on the taxpayer not exceeding 1% of the value

of each international transaction. Such penalty shall be levied without prejudice to the provisions

of chapter XV of the Ordinance, which deals with imposition of penalties.

For a failure to comply with the notice or requisition under section 107D of the ordinance by the

Deputy Commissioner of Taxes, the tax officer may impose a penalty on the taxpayer not

exceeding 1% of the value of each international transaction. For a failure to furnish a report from

a Chartered Accountant as required by section 107F of the Ordinance, the tax officer may impose

a penalty on the taxpayer of an amount not exceeding Taka 300,000 (approx. US$ 3,900).

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Chapter 8: Transfer Pricing and Life Cycle The life cycle of a product has an effect on transfer pricing much as it has an effect on divisional

performance evaluation. Divisions that have products in the embryonic, growth, mature, and/or

aging stages have different needs in transfer pricing. While a selling division may have a

component in the mature stage, the buying divisions final product may be in its embryonic stage.

This situation sets up a new dimension to be considered.

Take the different stages of a life cycle and the selling division.

Embryonic Stage: Embryonic stage is characterized by:

No market price for a Product.

Quite Elastic Price due to new technology that could benefit a buying division.

Research and Development go on.

Divisions acquire and test new production facilities.

Thus it is difficult to set TP from either the market or cost perspective.

Growth Stage: Growth stage is characterized by:

Selling Division is interested in developing an ongoing market for its product.

Design, Cost and Quality issues are resolved.

Market Share, Profit margins, Cash Flow and Improvement in productivity are

emphasized.

Thus in this Stage Market Based TP takes Place.

Maturity Stage: Maturity stage is characterized by:

Market is settled and the Selling Division tries to maintain its share.

Cash Flow and Cost Control are paramount.

Pressure on Market Price as competition leads to additional capacity.

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Buying Division is more powerful in negotiation here despite market prices are more reasonable

TP.

Aging Stage: Aging stage is characterized by

Dramatic movement of Power to the buying Division.

Decisions regarding when to abandon the product.

Internal use is emphasized.

Thus Power from selling division shifts to Buying Division.

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Chapter 9: Mathematical Problems and Solutions

Problem 1: The Assembly Division of SLOWCAR Company has offered to purchase 90,000 batteries from the

Electrical Division (ED) for $104 per unit. At a normal volume of 250,000 batteries per year, production

costs per battery are:

Direct materials $40

Direct labor 20

Variable factory overhead 12

Fixed factory overhead 42

Total $114

The Electrical Division has been selling 250,000 batteries per year to outside buyers for $136 each.

Capacity is 350,000 batteries/year. The Assembly Division has been buying batteries from outside

suppliers for $130 each.

Should the Electrical Division manager accept the offer? Will an internal transfer be of any benefit to the

company?

Solution 1:

ED manager should accept.

There is surplus capacity. So the relevant costs to the ED is the VC = $72 / battery.

The increased CM to the ED would be 90,000*($104 72) = $2.88 M

The company would be better off with an internal transfer. Currently paying $130 for batteries that could

be made internally for incremental cost of $72. The company would save 90,000 * (130 72) = $5.22 M per year!

The TP range = maximum of $130 to low of $72

What if there is no excess capacity?? (Maximum = $130, but minimum= $136)

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Problem 2: Minimum transfer price = incremental (outlay) costs/unit to point of transfer + opportunity

cost/unit to the supply division.

The SF Manufacturing Co. has two divisions in Iowa, the Supply Division and the BUY Division.

Currently, the BUY Division buys a part (3,000 units) from Supply for $12.00 per unit. Supply

wants to increase the price to BUY to $15.00. The controller of BUY claims that she cannot afford

to go that high, as it will decrease the divisions profit to near zero. BUY can purchase the part

from an outside supplier for $14.00. The cost figures for Supply are:

Direct Materials $3.25

Direct Labor 4.75

Variable Overhead 0.60

Fixed Overhead 1.20

A. If Supply ceases to produce the parts for BUY, it will be able to avoid one-third of the fixed MOH.

Supply has no alternative uses for its facilities. Should BUY continue to get the units from Supply

or start to purchase the units from the outside supplier? (From the standpoint of SF as a whole).

What is the minimum & maximum transfer price if BUY and SUPPLY negotiate?

MAX. TP = $14.00 / unit (most BUY is willing to pay, market price)

MIN. TP = $8.60 + (1/3 * 1.20) = $9.00

MAX > MIN so transfer internally would happen and be in the best interests of SF!

Now, assume that Supply could use the facilities currently used to produce the 3,000 units for

BUY to make 5,000 units of a different product. The new product will sell for $16.00 and has the

following costs:

Direct Materials $3.00

Direct Labor 4.30

Variable Overhead 5.40

B. What is the minimum & maximum transfer price if BUY and SUPPLY negotiate?

Supply VC = $8.60 + lost CM

Lost CM = $16 12.70 = $3.30 / unit of new product = $16,500 total lost CM OR $16,500 / 3,000 units transferred to BUY = $5.50/unit made for BUY

MAX. TP = $14.00

MIN. TP = $8.60 + $5.50 = $14.10

C. What should be done from the companys point of view? Why? SF is better off for SUPPLY to make new product and BUY to get part from outside.

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Problem 3:

Division A is a Profit Center. It produces -

SL Product External Demand Max

1. X 800

2. Y 500

3. Z 300

Product Y can be transferred to Division B but the maximum quantity of units that might be

required to transfer is 300 Units of Y.

Instead of receiving Product Y from Division A, Division B could buy the product Y from external

market at the rate of 45 BDT.

What should be the transfer price be for each of 300 units of Y if the total hours available for

division A is 3800 or 5600?

The Following Information is Available-

X Y Z

Selling Price Per Unit 48 46 40

Variable Cost Per Unit 33 24 28

Hours Required for Per Unit 3 4 2

Solution 3:

Statement Showing CM/U, CM/H & Rank

X Y Z

External Selling Price/Unit 48 46 40

Variable Cost/Unit (33) (24) (28)

Contribution Margin/Unit 15 22 12

Hours Per Unit Required 3 4 2

Contribution Margin Per Hour 5 5.5 6

RANK 3 2 1

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Statement Showing Production Plan for Maximum Profit

Hours Available

Product Unit * Hours/Unit = TOTAL Balance

3800 Z 300 * 2 = 600 (3800-600)

Y 500 * 4 = 2000 (3200-2000)

X 400 * 3 = 1200 (1200-1200)

Manufacturing Cost of 300 Unit of Y = 300 * 24 = 7200

+ Opportunity Cost of Leaving X of 400 Units = 400 * 15 = 6000

= 13,200 / 300 Units of Y

= 44 / Unit of Y T.P.

What would happen if 1800 hours were required for Y to transfer in Division B

instead of 1200 Hours?

Manufacturing Cost of Y = 7200

+ Opportunity Cost X + Y = (400*15 + 150*22)

If Say, after meeting the external Demand, still 500 hours is left to Division A. what

will happen?

Hour Required for Transfer. 1200

- Hours Available in A. (500)

= 700 hours/ 3 will be required to cut from X to meet the transfer.

If 5600 hours

Statement Showing Production Plan for Maximum Profit

Hours Available

Product Unit * Hours/Unit = TOTAL Balance

5600 Z 300 * 2 = 600 (5600-600)

Y 500 * 4 = 2000 (5000-2000)

X 800 * 3 = 2400 (3000-2400)

Manufacturing Cost of 300 Unit of Y = 300 * 24 = 7200

+ Opportunity Cost of Leaving X of 200Units = 200 * 15 = 3000

= 10,200 / 300 Units of Y

= 34 / Unit of Y T.P.

Page | 43

Problem 4: Hello.Com has two independent Divisions that produce Butter & Ghee respectively. Division-1

produces Butter which it can sale to outsiders at BDT 25 each. The variable cost per unit to

Division-1 is BDT 10 and fixed cost per unit is BDT 5 (It has already passed the Break Even point).

The Division-2s profit markup is 40%.

Q 1: What is the Market Based Transfer Price?

Q 2: What is the Minimum Transfer Price?

Q 3: What is the Cost plus Transfer price?

Solution 4:

Market based Transfer Price = 25 (Market Price)

Minimum Transfer Price = 10 (Variable Cost)

Cost Plus Transfer Price = 10 + 4 = 14

Problem 5: (Multinational Transfer Pricing)

Consider an item manufactured by ABC LTD (BD) with and 8% Income Tax rate and Transfer to

a Division in India with 40% Income Tax Rate.

Suppose India impose import duty equal to 20% of the price of the item and that ABC cannot

deduct this import duty for the tax purposes.

Full Cost= 100, VC= 60; If the tax authority allows either variable or full-cost TP, which should

ABC choose?

Solution 5:

Income of the BD division is 40 higher, so it pays (40* 8%) = 3.20 more tax Income of the India Division is 40 lower. So, it pays (40*40%) =16 less tax. Import duty is paid by the India Division on an additional (100-60) = 40. So it pays more

(40*20%) = 8 more.

Net saving from transferring at 100 instead of 60 is (16 -3.2- 8) = 4.8

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Conclusions While transfer pricing has been the subject of much theoretical argument over the years, both

general economic and accounting theory seem too limited by assumptions or too narrow in scope

to guide operating managers. What can be gleaned from theory is that company should incorporate

opportunity costs in transfer prices. At full capacity, the opportunity cost is based on market prices.

When excess capacity exists, opportunity costs are related to incremental variable and fixed costs

and/or some measure of capacity.

In practice, it seems that more companies use market based transfer prices than cost based ones.

Within the companies using cost-based prices, full costs seem to prevail counter to what theory

predicts. Negotiation and dual prices are options that many companies employ.

Transfer prices cannot be viewed in a vacuum. Life-cycle issues are important. In addition, since

transfer prices are part of the concept of decentralization and segment/managerial evaluation, all

aspects of transfer pricing have behavioral consequences.

It is not easy to prescribe the best transfer pricing have behavioral consequences. As with segment

evaluation, many factors need to be considered. However, if companies make sure that transfer

pricing is consistent with overall strategic planning, there is together likelihood that there will be

success.

Page | iv

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