What Are The Objectives Of Transfer Pricing?

  • Work-from-home

Pari

(v)i§§· ßµølï ßµð£ï¨
VIP
Mar 20, 2007
46,142
19,780
1,313
Toronto, Canada
What are the objectives of Transfer Pricing?

Transfer price if designed appropriately has the following objectives:
•It should provide each segment with the relevant information required to determine the optimum trade-off between company costs and revenues.

•It should induce goal congruent decisions-i.e. the system should be so designed that decisions that improve business unit profits will also improve company profits.

•It should help measure the economic performance of the individual profit centers.

•The system should be simple to understand and easy to administer.

What is ideal transfer price in the situations of
a.Limited Market
b.Shortage of Capacity in the industry

The ideal transfer price in the situations of :

a. Limited Market
By limited market it means that the markets for buying and selling profit centers may be limited. Even in case of limited market the transfer price that is ideal or satisfies the requirement of a profit center system is the competitive price. In case if a company is not buying or selling its product in an outside market there are some ways to find the competitive price.

They are as follows:
1.If published market prices are available, they can be used to establish transfer prices. However, these should be prices actually paid in the market-place and the conditions that exist in the outside market should be consistent with those existing within the company.For example, market prices that are applicable to relatively small purchases are not valid in this case.

2. Market prices are set by bids.
This generally can be done only if the low bidder has a reasonable chance of obtaining the business. One company accomplishes this
– by buying about one-half of a particular group of products outside the company
–and one-half inside the company.The company then puts all of the products out to bid, but selects one-half to stay inside. The company obtains valid bids, because low bidders can expect to get some of the business. By contrast, if a company requests bids solely to obtain a competitive price and does not award the contracts to the low bidder, it will soon find that either no one bids or that the bids are of questionable value.

1. If the production profit center sells similar products in outside markets, it is often possible to replicate a competitive price on the basis of the outside price.

2.If the buying profit center purchases similar products from the outside market, it may be possible to replicate competitive prices for its proprietary products. This can be done by calculating the cost of the difference in design and other conditions of sale between the competitive products and the proprietary products.

a. Shortage of Capacity in the industry

In this case, the output of the buying profit center is constrained and again company profits may not be optimum. Some companies allow either buying profit center to appeal a sourcing decision to a central person or committee. In this scenario a buying profit center could appeal a selling profit center’s decision to sell outside.The person/group would then make a sourcing decision on the basis of the company’s best interests. In every case the transfer price would be the competitive price. In other words, the profit center is appealing only the sourcing decision.Even if there are constraints on sourcing, the market price is the best transfer price. If the market price can be approximated, it is ideal transfer price.

When do you use Cost Based Transfer Pricing?
We use cost-based transfer pricing if there is no way of approximating valid competitive price.Transfer prices may be set up on the basis of cost plus a profit, even though such transfer prices may be complex to calculate and the results less satisfactory than a market-based price.Two aspects need to be considered for cost-based transfer pricing:

1. The cost basis:
The usual basis is the standard cost. Actual costs should not be used because production inefficiencies will then be passed on to the buying profit center. If the standard costs are used, there is a need to provide an incentive to set tight standards and to improve standards.

2.The profit markup:
In calculating the profit markup, there also are two decisions:

What is the profit markup to be based?
The simplest and most widely used base is percentage of costs. If this base is used, however, no account is taken of capital required. A conceptually better base is a percentage of investment. But there may be a major practical problem in calculating the investment applicable to a given product. If the historical cost of the fixed assets is used, new facilities designed to reduce prices could actually increase costs because old assets are undervalued.

What is the level of profit allowed?
The second problem with the profit allowance is the amount of the profit. The conceptual solution is to base the profit allowance on the investment required to meet the volume needed by the buying profit centers. The investment would be calculated at a “standard” level, with fixed assets and inventories at current replacement costs. This solution is complicated and, therefore, rarely used in practice.
 
Top