Question

“Explain transfer prices and four criteria used to evaluate them. Illustrate how marketbased transfer prices promote goal congruence in perfectly competitive markets. Discuss objectives and how Influences on Transfer Pricing Decisions is possible?”

Answer 1

A transfer price is the price at which divisions of a company transact with each other, such as the trade of supplies or labor between departments. Transfer prices are used when individual entities of a larger multi-entity firm are treated and measured as separately run entities. A transfer price can also be known as a transfer cost.

1. Cost-based transfer pricing

Cost-based transfer pricing is the simplest transfer pricing method. It assumes using

standard costs as a basis of pricing on the way that does load neither buying profit center

nor selling profit center in exchanging intermediate product/service. The method of "full

product costs" include all production costs as well as costs from other business functions

and it could be applied for intermediate products with specific characteristics that cannot

be found on the external market.

2. Negotiated transfer pricing

A negotiated price is set by negotiations between buying and selling profit centers . In certain cases, the units of an enterprise are free to negotiate the transfer price

between them

3. Market-based transfer pricing

Where a competitive market price exists for the output of a profit center, such as the

price charged to external customers, the market price is thought to be the most objective

measure of the economic value of the product or service being internally transferred. The

internal transfer will be made where component is equal to component

of the external seller in quality and price.

4. Transfer pricing by the method of synthetic market price

In case of the possible absence of an internal market and the failure of the external

market price with a synthetic market price will be

introduced. The synthetic market price is computed as follows:

Synthetic market

price = Variable costs

of the selling profit center + Opportunity cost

to the enterprise as a whole

where opportunity costs are defined as the maximum contribution forgone by the

enterprise missing the best supply on the external market. The synthetic market

price will always "send" the proper signals to the buying profit center, so it is often

marked as the "ideal transfer price" or the "optimum transfer price" . It

determines the transfer price, which enables optimal decision-making from the standpoint

of the enterprise as a whole in the different specific situations.

Symantec Wins $545 million Opinion in

Transfer Pricing Dispute with the IRS1

Symantec Corp., a large U.S. software company, won a significant

court decision in December 2009, potentially saving it $545 million in

contested back taxes. The Internal Revenue Service (IRS) had been

seeking back taxes it alleged were owed by Veritas Software Corp., a

company acquired by Symantec in 2005. The dispute was over the

company’s formula for “transfer pricing,” a complex set of rules

determining how companies set prices, fees, and cost-allocation

arrangements between their operations in different tax jurisdictions.

At issue were the fees and cost-allocation arrangements between

Veritas and its Irish subsidiary. Ireland has emerged as a popular tax

haven for U.S. technology companies. Veritas granted rights to Veritas

Ireland to conduct research and development on various intangibles

(such as computer programs and manufacturing process

technologies) related to data storage software and related devices.

Under the agreement in effect, Veritas Ireland paid $160 million for this

grant of rights from 1999 to 2001. Based on a discounted cash flow

analysis, the IRS contended that the true value of the transferred rights

was closer to $1.675 billion. As a consequence, it claimed that the

transaction artificially increased the income of Veritas Ireland at the expense of income in the U.S. parent corporation, consequently

lowering the U.S. tax bills during this period.

Veritas, however, maintained that it acted appropriately.

The company testified that the $160 million figure was based on

royalty rates it had received from seven original equipment

manufacturers (OEMs) for rights to incorporate Veritas United

States’ software and technologies into an operating system,

with adjustments made for purposes of comparability. At trial,

the United States Tax Court supported this position, and called

the IRS’s valuation of the intangibles “arbitrary, capricious, and

unreasonable.” Among other things, the court took issue with

the discount and growth rates used in the IRS expert’s analysis,

and disagreed with his assumption that the transferred

intangibles had a perpetual useful life.

Though not all companies face

multinational tax concerns, transfer-

pricing issues are common to many

companies. In these companies, transfer

pricing is part of the larger management control system. This chapter

develops the links among strategy, organization structure, management

control systems, and accounting information. We’ll examine the

benefits and costs of centralized and decentralized organization

structures, and we’ll look at the pricing of products or services

transferred between subunits of the same company. We emphasize

how accounting information, such as costs, budgets, and prices, helps

in planning and coordinating actions o

Objectives of Transfer Pricing

1. Goal congruence: The prices should be set so that the divisional management desire to maximize divisional earnings is consistent with the objectives of the company as a whole. The transfer prices should not encourage sub-optimal decision-making. The system should be so designed that decisions that improve business unit profits will also improve company profits.

2. Performance appraisal: The prices should enable reliable assessments to be made of divisional performance. The prices form part of information, which should:

Guide decision making

Appraise managerial performance

Evaluate the contribution made by the division to overall company profits.

Assess the worth of the division as an economic unit.

The transfer prices should be designed such that they help in measuring the economic performance

3. Divisional autonomy: The prices should seek to maintain the maximum divisional autonomy so that the benefits of decentralization (motivation, better decision-making, initiatives, etc.) are maintained. The profits of one division should not be dependent on the actions of other divisions.

f subunits.

Objectives of Transfer Pricing

1. Goal congruence: The prices should be set so that the divisional management desire to maximize divisional earnings is consistent with the objectives of the company as a whole. The transfer prices should not encourage sub-optimal decision-making. The system should be so designed that decisions that improve business unit profits will also improve company profits.

2. Performance appraisal: The prices should enable reliable assessments to be made of divisional performance. The prices form part of information, which should:

Guide decision making

Appraise managerial performance

Evaluate the contribution made by the division to overall company profits.

Assess the worth of the division as an economic unit.

The transfer prices should be designed such that they help in measuring the economic performance

3. Divisional autonomy: The prices should seek to maintain the maximum divisional autonomy so that the benefits of decentralization (motivation, better decision-making, initiatives, etc.) are maintained. The profits of one division should not be dependent on the actions of other divisions.

4. Simple and easy: The system should be simple to understand and easy to administer.

5. The transfer price should provide each segment with the relevant information required to determine the optimum trade-off between company costs and revenues.

Well understood in economics, accounting, finance, and legal research, transfer pricing has rarely been comprehensively explored in organization management literature. This paper explores some theoretical explanations of transfer pricing within multidivisional firms drawing insights from various organizational theories – primarily institutional theory, transaction cost economics, and social networks – to develop a conceptual model of transfer pricing. This model focuses on the nature of multidivisional firms’ internal transfers, internal and external technological environments, and internal and external social environments. We highlight the importance of transfer pricing as a key strategic dimension to understand intra-firm flows and their associated costs.