Question

(a) Why do firms practice transfer pricing?

Explain how transfer pricing is affected when:

(b) There is a competitive external market for the intermediate product. (c) There is a non-competitive external market for the intermediate product.

Answer 1

a. Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods paid by the parent to the subsidiary is the transfer price. Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors. Transfer pricing can be used as a profit allocation method to attribute a multinational corporation's net profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among divisions within an enterprise.

Transfer pricing multi-nationally has tax advantages, but regulatory authorities frown upon using transfer pricing for tax avoidance. When transfer pricing occurs, companies can book profits of goods and services in a different country that may have a lower tax rate. In some cases, the transfer of goods and services from one country to another within an interrelated company transaction can allow a company to avoid tariffs on goods and services exchanged internationally. The international tax laws are regulated by the Organization for Economic Cooperation and Development (OECD), and auditing firms within each international location audit financial statements accordingly.

Transfer pricing helps in reducing the duty costs by shipping goods into high tariff countries at minimal transfer prices so that duty base associated with these transactions are low. Reducing income taxes in high tax countries by overpricing goods that are transferred to units in those countries where the tax rate is comparatively lower thereby giving them a higher profit margin. By charging above or below the market price, firms can use transfer pricing to transfer profits and costs to other divisions internally to reduce their tax burden. Tax authorities have strict rules regarding transfer pricing to attempt to prevent companies from using it to avoid taxes.

b. When there is a competitive external market for the transferred product, market prices work well as transfer prices. When transferred goods are recorded at market prices, divisional performance is more likely to represent the real economic contribution of the division to total company profits. If the goods can not be bought from a division within the company, the intermediate product would have to be purchased at the current market price from the outside market. Divisional profits are therefore likely to be similar to the profits that would be calculated if the divisions were separate organisa­tions.

Consequently, divisional profitability can be compared directly with the profitability of-similar companies operating in the same type of business. Managers of both buying and selling divisions are indifferent between trading with each other or with outsiders. No division can benefit at the expense of another division. In the market price situation, top management will not be tempted to intervene.

Market-based prices are based on opportunity costs concepts. The opportunity cost approach signals that the correct transfer price is the market price. Since the selling division can sell all that it produces at the market price, transferring internally at a lower price would make the division worse off.

Similarly the buying division can always acquire the intermediate goods at the market price, so it would be unwilling to pay more for an internally transferred goods. Since the minimum transfer price for the selling division is the market price and the maximum price for the buying division is also the market price, the only possible transfer price is the market price.

The market price can be used to resolve conflicts among the buying and selling divisions. From the company viewpoint, market price is the optimal so long as the selling division is operating at full capacity. The market price does not allow any gains or losses in efficiency of the selling divi­sion. It saves administrative costs as the use of competitive market prices are free from any dispute, argument and bias.

Further, transfer prices based on market prices are consistent with the responsibility accounting concepts of profit centres and investment centres. In addition to encouraging division managers to focus on divisional profitability, market based transfer prices help to show the contribution of each division to overall company profit.

c.) When there is no external demand for the intermidiate product, the production division can sell the intermidiate product only internally to the marketing division of the firm, and the marketing division can purchase the intermediate product only from the production division of the firm. Since 1 unit of the intermediate product is used to produce each unit of the final product, the outputs of the intermediate products and of the final product are equal.

Sometimes, there will be non-competitive external market at all for the product being supplied by the selling division; perhaps it is a particular type of component being made for a specific company product. In this situation, it is not really appropriate to adopt the approach above. In reality, in such a situation, the selling division may well just be a cost centre, with its performance being judged on the basis of cost variances. This is because the division cannot really be judged on its commercial performance, so it doesn’t make much sense to make it a profit centre. Options here are to use a cost based approach to transfer pricing but these also have their advantages and disadvantages.

Cost based approaches

Variable cost
A transfer price set equal to the variable cost of the transferring division produces very good economic decisions. If the transfer price is $18, Division B’s marginal costs would be $28 (each unit costs $18 to buy in then incurs another $10 of variable cost). The group’s marginal costs are also $28, so there will be goal congruence between Division B’s wish to maximise its profits and the group maximising its profits. If marginal revenue exceeds marginal costs for Division B, it will also do so for the group.

Although good economic decisions are likely to result, a transfer price equal to marginal cost has certain drawbacks:

Division A will make a loss as its fixed costs cannot be covered. This is demotivating.

Performance measurement is also distorted. Division A is condemned to making losses while Division B gets an easy ride as it is not charged enough to cover all costs of manufacture. This effect can also distort investment decisions made in each division. For example, Division B will enjoy inflated cash inflows.

There is little incentive for Division A to be efficient if all marginal costs are covered by the transfer price. Inefficiencies in Division A will be passed up to Division B. Therefore, if marginal cost is going to be used as a transfer price, it at least should be standard marginal cost, so that efficiencies and inefficiencies stay within the divisions responsible for them.

Full cost/Full cost plus/Variable cost plus
A transfer price set at full cost or better, full standard cost is slightly more satisfactory for Division A as it means that it can aim to break even. Its big drawback, however, is that it can lead to dysfunctional decisions because Division B can make decisions that maximise its profits but which will not maximise group profits. For example, if the final market price fell to $35, Division B would not trade because its marginal cost would be $40 (transfer-in price of $30 plus own marginal costs of $10). However, from a group perspective, the marginal cost is only $28 ($18 + $10) and a positive contribution would be made even at a selling price of only $35. Head office could, of course, instruct Division B to trade but then divisional autonomy is compromised and Division B managers will resent being instructed to make negative contributions which will impact on their reported performance. Imagine you are Division B’s manager, trying your best to hit profit targets, make wise decisions, and move your division forward by carefully evaluated capital investment.

The full cost plus approach would increase the transfer price by adding a mark-up. This would now motivate Division A, as profits can be made there and may also allow profits to be made by Division B. However, again this can lead to dysfunctional decisions as the final selling price falls.

The difficulty with full cost, full cost plus and variable cost plus is that they all result in fixed costs and profits being perceived as marginal costs as goods are transferred to Division B. Division B therefore has the wrong data to enable it to make good economic decisions for the group – even if it wanted to. In fact, once you get away from a transfer price equal to the variable cost in the transferring division, there is always the risk of dysfunctional decisions being made unless an upper limit – equal to the net marginal revenue in the receiving division – is also imposed.