Question

1. Explain transfer pricing in organizations. Why does management use transfer pricing? Discuss various methods for determination of transfer prices.

[25 marks]

Answer 1

TRANSFER PRICING

                            Transfer pricing can be defined as the setting of prices for the goods and services sold between related entities. If a parent company buys goods from a subsidiary company, the price paid be the parent company to the subsidiary company can be called as transfer price. Transfer pricing extends to both domestic as well as international transactions between related entities. Transfer pricing helps the management in various ways. Transfer pricing helps in reducing duty of goods shipped to other nations where tariff rates are high. This is done by minimizing the transfer price thereby reducing the duty of the transaction. Transfer pricing helps companies to reduce income taxes in countries that have comparatively high tax by overpricing its goods.

Methods of determining transfer price:
01.The Comparable Uncontrolled Price
Unlike other methods, the CIP method is based on fair market price. This is one of the most common ways of determining transfer price. This method compares the price of goods in a related company transaction to the price of the same transaction between unrelated parties.

02.Cost plus Percent Method
This method compares gross profit to cost of sales. The party supplying the good determines the cost of the transaction and adds a mark up profit to the cost.

03.The Resale Price Method
This method looks at the difference between the price at which a product is purchased and the price at which it is sold to a third party.

04.Transaction Net Margin Method
This method compares the margin of net profit earned in a related party transaction to the margin of gross profit earned in a similar transaction with a third party.

05.Profit Split Method
In this method, the transfer price is determined by evaluating how to profit arising from one transaction would be divided between autonomous businesses involved in the transaction.