Model - 4

Transfer Pricing

Introduction :

One of the important corporate objectives is the maximization of profit. It is

very well known that the amount of profit and the rate of profit depend upon
the amount of expenditure incurred, the sum of revenue earned and also the
total of capital raised and employed on its variegated types of assets. In
order to maximize its profit, the organization has to concentrate on all the
three determinants. It has to raise the requisite capital from the most
economical sources and the capital so raised shall be employed judiciously
so that optimum return on each rupee of capital employed may be obtained.
Since the investment pattern and also how profitably the capital has been
employed influence the cost and the revenue, it is necessary to lay greater
emphasis on these aspects.

The amount of revenue is influenced by both the internal and the external
factors. Since the nature of competition has gradually been transforming
from a healthy competition to a destructive type of competition, the price
and the volume of sales - the two determinants of revenue - are swayed
more by the external factors though the internal factors are also having their
own role to play. Consequently, the revenue factor does not provide much
scope for improving the profitability.

The amount of expenditure incurred by an organization depends on both the

internal and the external factors. But the control can be exercised on costs to
a greater extent and therefore, provide the most potential avenues for cost
reduction leading to the increase in the earnings. Because, no element of
cost is in such a condition that its cost cannot further be reduced. This
analysis clearly brings out the fact that the enterprises should concentrate
largely on internal factors, not leaving even a single opportunity, to improve
their performance. This is what one can witness today in the corporate
sector.

DEFINITION-TRANSFER PRICING

Transfer pricing is the setting of the price for goods and services sold
between related legal entities with an enterprise.
E.g.: If a Subsidiary Company sells goods to a parent company, the cost of
those goods is the transfer price.

Pre-requisites-cum-Procedure

For the successful introduction and operation of intra-firm comparison

scheme, it is necessary for the management of the company to take proper
decisions on some of the aspects such as (a) Divisionalisation , (b) Forms of
Divisions, (c) Transfer Price Methods, and (d) Yardsticks for Performance
Evaluation. These points are analyzed little elaborately in the following
paragraphs.

1. Divisionalisation: One of the basic pre-requisites for the introduction of a

scheme for intra-firm comparison is the division of entire organization into
few meaningful segments or units wherein each unit or segment is called a
division or department or center . Divisionalisation may be effective either on
the basis of the functions or on the basis of the market distinctions as
explained below

 Classification: An organization may be divided into two or more

divisions on the basis of the functions they perform such as Purchase
Division , Engineering Division, Manufacturing Division, Finance
Division, Sales Division, etc. Further, Manufacturing Division may be
divided into two or more sub-divisions such as Manufacturing
Department - 1 or Manufacturing Process - A, Manufacturing
Department - II or Manufacturing Process - B. etc. For instance, in the
case of sugar factory, sugar cane is introduced into the manufacturing
process and it passes through five important and distinct processes
before it is being converted into sugar. The processes are Mill House,
Boiler House, Power House, Evaporation House and Bagging House. In
this case, each house may be reckoned as a division While dividing
the organization, care should be taken to ensure that each division has
certain activities to perform, each division should be separable and
identifiable for operating purposes and the performance of each
division should be measurable .
 Product or Market-wise Classification:

Compared to the function-wise division of the organization, product or

territory-wise division is an easier one. This task is much easier in the case of
multi-product concerns wherein each product can conveniently and gainfully
be reckoned as a segment. For instance, The Mysore Paper Mills Limited,
Bhadravati is a multi-product concern as it is engaged in the manufacturing
of both paper and sugar. the first division may further be divided into four
sub-divisions wherein each type of paper may be considered as a separate
segment and therefore, as a separate accounting entity

[Link] of Divisions:

As explained earlier, the successful introduction and implementation of

intra- firm comparison scheme to a larger extent, depends upon how
efficiently the organization is divided into few divisions. A division is a part
or segment of an organization under the supervision of a manager who
has the responsibility for that division's activities. A division may take the
form of either a cost center or a profit center or an investment center or
any combination of these depending upon the authority delegated and
the yardsticks or the criteria that the management intends to apply for
the purpose of divisional or inter-division or intra-firm comparison.

 Cost Centers :
A cost center is simply a segment of an organization where costs are
incurred and accumulated. The performance of a cost center is
measured in terms of economies achieved in costs, effectiveness in the
acquisition and utilization of resources, efficiency with which goods are
produced, etc. It can also be appraised by comparing the actual costs
with the standard or budgeted costs. But a problem crops up at this
stage as to what costs shall be reckoned for comparison purposes.
Because, the total costs traceable with a divisions comprise of both
controllable and non-controllable costs. Controllable costs are those
costs which are normally incurred by the head of the division for
acquiring and using the resources and which can considerably be
influenced by the actions of the division's head.
Besides, there are some other costs which are attributable to the
operations of a division but not significantly influenced by the actions
of the manager of the division under consideration. Therefore, they are
no-controllable costs from the view point of this division but are
controllable by others .
The aggregate of controllable and non-controllable costs represents
the costs attributable to the operations of a division and therefore, the
aggregate may be termed as traceable costs.

3. Profit Centers:
A profit center is a segment of an organization which may conveniently
be viewed as a business unit within a business organization as it is
 responsible for both costs and revenues. It is very well known that, in
order to earn profit, costs are incurred, and sales are effected and
revenue is earned. Costs are charged against the revenue to ascertain
the result in the form of profit. That means, in a profit center, costs are
incurred and accumulated and therefore, a profit center is invariably a
cost center. But, not all cost centers are profit centers. As a result, one
can find more number of cost centers than the number of profit
centers. As the revenue is earned through the sales by the profit
centers, the profit centers may also be termed as revenue centers.
The performance of a profit center can be measured either on the basis
of the controllable costs and revenue or on the basis of traceable costs
and revenue . The importance of profit centers has widely been
recognized by the corporate sector. It is because of the reason that the
profit centers enable the management to appraise both the cost
effectiveness and the profitability.
3 . Investment Centers: Investment center is a division of an
organization wherein its performance is assessed by considering not
only its costs and revenues but also by establishing the relationship
between profit , capital invested or employed and revenue. The
performance of a division is measured by establishing the relationship
between its net income and total capital employed in that division.
3. Decision about Intra-Firm or Inter-Division Transfer Pricing
Method:
The transfer price represents the price at which the goods or services
of a division are transferred to another division of the same
organization and under the same management control. As this
transfer price is a revenue to the transferor division and a cost to the
transferee division, it has an impact on the costs, profits and revenues
of both the divisions accordingly.

Approaches to Transfer Pricing

1. Cost approaches
 Actual cost
* Full cost method.
* Variable cost method.
 Estimated or standard budgeted cost
2. Market – based transfer price
3. Negotiated price method
4. Cost plus method
5. Dual price method
 6. Arbitrary transfer method

Cost Based Transfer Prices: The cost approaches to transfer price are based
on sound principles as they take into account the expenditure incurred or
expected to be incurred by the transferor division to produce the commodity.
Further, accurate market price may not be available either due to the non-
availability of similar product or due to any other reason. It does not mean
that the cost approaches do not suffer from any limitation. They are also
having their own shortcomings.

If the transfer price is determined as equivalent to the standard cost, either

the transferor division or the transferee division or both may question or
challenge the very validity of the standard cost , if the transfer price is fixed
to equal the actual manufacturing cost, the efficiency or otherwise of the
transferor division is passed on to the transferee division in the form of
transferring the output of the transferor division at lower cost or at an
unreasonably higher cost as the case may be. This way even the approaches
based on cost suffer from few shortcomings.

Full cost method:

Under this method transfers are priced at the full cost which may be either
the actual total cost or the aggregate of actual controllable cost and the
estimated non-controllable cost or the standard cost. Under this approach,
both the efficiency and the inefficiency of the transferor division are passed
on to the next division and finally to the sales division . This approach
comparatively a simple one to compute the transfer price and it is also
fascicle to evaluate the year-end inventories as the price does not include
any unrealized profit . By comparing the actual cost with the standard or
budgeted cost, efficiency of a division can be assessed,

Standard Cost Method: Under this approach, transfers are effected at the
standard cost of production. The determination of standard costs is,
therefore, a pre-requisite. It is simple to operate due to many a number of
reasons. The standard cost data are readily available. The transfer prices do
not fluctuate due to the changes in the level of operation, price level,
incidence of fixed overhead expenses, etc. In spite of its simplicity, it has not
widely been recognized as a sound approach and therefore, its practical
application has been very much limited.

Marginal Cost Method: Under this method, transfer of output of one division
to another division is effected at the marginal or variable cost of production.
The variable production costs comprise of only those costs which are directly
and more or less,

proportionately influenced by the volume of output. Further, more or less, all

the elements of marginal cost represent the controllable items and therefore,
the efficiency of a division can well be assessed. Besides, there is no
frequent and significant changes in the transfer prices and therefore,
performance evaluation can effectively be made under this approach.

Market based Transfer Price:

This method of transferring the output of a division at the prevailing market

prices is based on the sound principle of opportunity cost. Market based
transfer price may be in the form of competitor's price or price quoted in the
bid received most recently. This approach may gainfully be used when the
output of each division are saleable independently in the open market. Then
only it is possible to obtain the market prices which the output of each
division fetch and these prices may be charged to effect the inter- divisional
transfers. The outside market prices may suitably be adjusted for any
difference in the conditions of sale or the difference in the delivery by the
outside supplier and by the inside transferor. In other words, the estimated or
actual selling and distribution expenses attributable to the output are usually
subtracted from the market price as the inter-divisional transfers do not
involve these expenses.

Negotiated Price Method: The transfer price, under this method, is based on
negotiation between the transferor division and the transferee division Of
course the managers of division take note of the quotations received from
the outsiders. This method assumes that the divisional managers enjoy
freedom alternative option because without this freedom there is ne scope
for bargaining . One of the important drawbacks of this approach is that the
ability of the divisional manager to obtain profitable price for the inter-
divisional transfers influences is division's profitability. Consequently, in
evaluating the performances of the divisions, the top management may be
evaluating the performances of the divisions to negotiate and to secure the
profitable prices for their divisions' output or to obtain their requirement at
the most economical price rather than their abilities to achieve economies in
the cost of production.

Dual Transfer Prices: Under this method, two sets of transfer prices are used
-one, the outside market price for transferor division and another the cost of
production of the transferor division for the transferee division. That means,
the transferor division's account is credited at the outside market prices (less
estimated selling and distribution costs) and the transferee division's account
is debited with the production costs incurred by the transferor of these
transfers.

Arbitrary Transfer Price:

The top management of the company constitutes a high-level committee and

assigns to it the responsibility of fixing the transfer prices for the outputs of
different divisions. The divisions have to transfer their output to the next
divisions at the price so determined by the committee. While fixing the
prices for the outputs of different divisions, the committee hears the views of
the divisional heads. Only after hearing the views of the divisional heads, the
committee fixes the transfer prices which should be acceptable to all the
divisions For the purpose of divisional performance evaluation

Cost Plus Method:

Under this approach, a margin of profit (at a pre-determined rate) is added

either to the full cost of production or to the variable cost of production to
arrive at the price at which intra-company transfers shall be made. The profit
margin is usually a pre-determined one which may be expressed as a
percentage of either the cost of production or the capital employed or the
sales revenue.

Performance Evaluation Criteria:

The computation of controllable and traceable costs, revenue and capital

employed poses number of practical difficulties, the accurate evaluation of
the performance of divisions fully depends upon the preciseness in the
computation .

1 that the lower levels of management of the organization are accountable to

the higher level management

2. that the entire human resource is striving to attain the corporate

objectives as determined by the management,

[Link] equitable and rational allocation of the corporate objectives among the
divisions of the organization, and

4. the neutral performance evaluation of the divisions by comparing their

responsibilities with the performance achieved.
Each division's overall performance may be assessed by using only the
controllable factors as presented below.

Divisional Rate of Return =( Controllable Revenue-Controllable Cost/

Controllable Capital * 100 )

This algebraic expression emphasizes on the role of divisional manager and

his staff with respect to their effort to identify and eliminate the unnecessary
costs,

b. their ability to promote the transfers and/or sales, and

c. the efficiency with which the capital has been utilized, etc.

As each division uses the services of other divisions, as each division's

revenue is, to some extent, influenced by others and as the capital employed
in a division's activities is influenced by others, it is necessary to incorporate
a share of these. Therefore,

Divisional Rate of Return =

(Traceable Revenue - Traceable Cost/Traceable Capital Employed×100)

By using these formula, one can assess the overall performance of each
division. But it is also necessary to assess the performance of a division from
the view point of both the physical resources and other financial resources.
Some of the parameters that may be evolved are on the following lines.

a. Comparison of actual percentage of waste of materials in the process of

production with that of either the budgeted percentage or the previous year
or other division's or the company's average,

b. Labour productivity,

c. Unit material cost,

d. Man-days lost,

e. Capacity utilization,

f. Percentage of scraps and defectives,

g. Machine breakdown,

h. Overtime and idle time costs,

i . Unit cost-specific and common, etc.

The difference between the expected and actual performance with respect to
each input face activity, sub-division, etc., shall be ascertained and the
responsible factors or the reasons identified Further, when a comprehensive
report is prepared by providing columns for different centers (i.e. divisions), it
facilitates the comparison of performance of one divisions with that of other
of the same organization. This creates a healthy competition among the
divisions so that each division makes its sincere endeavor to improve its
performance and to stand at the top in the comparative table. As a result,
the company is able to achieve what it has planned or desired to achieve
during the period.