Transfer Pricing and Methods to fix Transfer Pricing

Amount charged for sale of products or for services rendered is called a price.

Pricing is either external or internal. Pricing for goods sold / services rendered outside the business is called ‘External pricing’. When a transfer of goods or services takes place within the business (i.e. from one unit of the business to the other) for a price then it is called ‘Internal pricing’. Internal pricing is also called as ‘Transfer pricing’.

Intra-company transfer pricing is a concept used in decentralized organizations, especially when performance of sub-units of the organization is measured based on the profits generated by them (i.e. profit centers).

Decisions involving fixation of transfer price are made by the divisional managers involved in transfer of goods / services. Transfer price is revenue for the unit producing the product or service and cost to the unit acquiring the same. Profitability of the business as a whole does not get impacted by internal transfer price. Since divisional managers have complete control in fixing transfer prices there is a possibility that transfer price fixed adversely effects the other divisions or the business as a whole. The following example illustrates the same

Example:

Drug division of Innovative Labs transfers a material ‘Zumba’ to the Formulations division at $ 400 per unit. Formulations division has always depended on Drug division for this material. But when Drug division has informed that the transfer price for ‘Zumba’ would be increased to $ 500 per unit it started to look for outside suppliers.

Formulations division has found an outside supplier for material ‘Zumba’ who agreed to sell the product at $ 450 per unit. Drug division refuses to lower the transfer price in view of its need to maintain its return on investment.

In the above scenario not only the profit of Formulation division but also the profit of Innovative Labs as a whole would decrease by $ 50 per unit bought from outside supplier.

From overall Innovative Labs point of view this is a ‘make or buy’ decision. By buying ‘Zumba’ from outside supplier instead of making it within the company Innovative Labs will incur additional cost of $ 50 per unit.

Methods to fix Transfer pricing

Though there are many methods used in fixing intra company transfer prices, the following three methods and their variants are most commonly used
a) Cost based
i. Total cost based
ii. Marginal cost based
b) Market price based
c) Negotiated

Total cost pricing and total cost plus pricing:

This is a conventional method which considers both variable and fixed costs in determining the transfer price. A variant to this is total cost plus profit method. A couple limitations to the above method are
a) Profitability of each unit cannot be determined correctly.
b) Possibility of wrong decision making

Marginal cost / variable cost pricing and marginal cost plus pricing:

Under this method only variable costs are considered for determining the transfer price. Since this method does not include fixed costs it is more suitable for decision making. If the producing division of the product or service is currently operating at less than full capacity it may use marginal cost based pricing for any new orders it receives.

Market based pricing:

If the market price is available for a product being transferred internally, it may be considered for fixation of transfer price. Principles of opportunity cost are considered in this method.

Negotiated transfer price:

Transfer price is negotiated or bargained in this method. Both the divisions involved in the internal transfer may analyze the external market prices before deciding on the negotiated transfer price. In this method the negotiating ability of the divisions plays a more critical role than the producing ability.

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