Question

Transfer pricing generally follows a market-based, cost-based or negotiated approach. Describe the meaning of each of these approaches. (750 words)

Answer 1

Transfer price is the sum of the two cost components that are additional outlay cost per unit because goods are transferred and opportunity cost per unit to the organization because of transfer. In accounting, transfer pricing is the rules or methods for pricing transactions between enterprises under common ownership.

Mainly there are three approaches of transfer pricing are -

1. Market based approach

2. Cost based approch

3. Negotiated approach

Market based approach - Market based prices are based on opportunity cost concept. It tells that the correct transfer price is the market price. Market price is a price in an intermediate market between independent buyers and sellers. When transferred goods are recorded at market prices, divisional performance is more likely to represnt the real economic contribution of the division to total company profit.

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

Here are some problems using the market price approach :-

a) Finding a competitive market price may be difficult.

b) Difficulty in measuring opportunity cost.

c) When production capacity is high and it can not sell all its products.

Cost based approach - Companies adopt cost based price approach when external market do not exist or it can say that information about external market price is not available at a time.

Cost based market price may be in different forms such as variable cost, actual cost, cost plus profit margin and standard cost.

a) Variable cost - when selling division is operating below capacity then variable cost is used. In this pricing system, only variable production cost are transferred that are direct materials, direct labour and variable factory overhead.

b) Actual cost - transfer price is based on total product cost per unit which is used in the process of production which includes direct material, direct labour and factory overhead. Under it, selling division can not realise a profit on the goods transferred.

c) Cost plus profit margin - The full cost and profit includes the allowed cost of the item plus a mark up or profit allowance. With this, selling division obtains a profit contribution of units transferred and benefits if performance is measured on the basis of divisional operating profits.

d) Standard cost - standard cost are used as a transfer pricing in cost based system when to promote responsibility in the selling division and to isolate variances within divisions. This encourages efficiency in the selling division.

Negotiated approach - It may be neccessary to negotiate a transfer price between subsidiaries, without using any market price as a base line. This situation arises when there is no discrenible market price because the market is very small or the goods are highly customised. Under it, the managers involved act much the same as the managers of the independent companies.

Advantages of negotiated transfer pricing approach :-

1. It should enable the negotiated proce to be closed to the opportunity cost of one or both divisions.

2. Freedom to buy or sell outside which provides the necessary discipline to the bargaining process.

3. It avoids a bilateral monopoly situation in which the final price could vary.

4. Top management support is helpful.

Disadvantages are :-

1. Time, resources and management effort can be consumed.

2. It leads to conflicts between the division.

3. One divisional manager having some private information may take advantage of another divisional manager.

4. Performance measures will be distorted leading to incorrecr evaluation of divisional performance.