Transfer pricing is when each of two entities or two parts of one company charges a different price for goods and services.
Transfer pricing requires careful consideration and an expert assessment of the risks and rewards involved. It is not just a mechanical process; it involves several variables that require careful analysis and professional opinion.
The concept of transfer pricing is not new, but its application in practice is complex. In practice, transfer pricing can be used to transfer profits and costs among different divisions, divisions within the same group, groups within a parent company and even among different countries.
Transfer Pricing Policies
The transfer pricing policies are adopted by the company based on the evaluation of risks involved, use of assets and market conditions.
Cost Plus Method
The cost-plus method focuses on the related manufacturing department as the tested party in transfer pricing analysis. It begins with the cost incurred by the department, and markup is then added to this cost to make a reasonable profit because of functions performed, the risk assumed, and assets used. It is calculated with the help of the following formula:
Transfer Price = Cost + Markup for Selling Division
The cost-plus method is used to analyse transfer price issues that involve tangible property or service. It is most useful when it is applied to manufacturing or assembling activities. This method evaluates the arm-length nature of inter-department charges regarding the gross profit markup on costs incurred by the supplier department.
This method compares the gross profit markup earned by the department manufacturing the product to the gross profit markup point by other comparable departments. If we assume, the cost of manufacturing of department per unit comes to $5,000, and we assume the gross profit markup of the department in the associate enterprise should earn is 50%. The resulting transfer price will be $5,000 + 50% of 5,000 = $7,500.
Fair Market Value Method
This method can be applied if the product is salable as manufactured by the department without further processing. Under the fair market value method, the transfer price from one department to another is the product’s market price that the transferor department is manufacturing.
This method presumes that the transferor department has manufactured the goods and earned the profit for the company with the assumption that the goods are sold in the market and the transferee department purchases the article from the market. What will be the cost of the transferee department? This method justifies the performance of the transferor department and the transferee departments.
Price Negotiated by the Managers
Sometimes neither the cost plus markup price nor the market price is the transferred price of the product, but it is mutually decided by the managers of the transferor and transferee departments. The managers consider the transferor department’s cost and the reasonable profits that should be assigned to the transferor department for its efforts and utilisation of assets and risks borne by the department in the manufacturing of the product.
At the same time, the concerning cost to the transferee department is also considered so that the transferee department’s cost is not overstated. This method provides a better understanding and reduces conflict of interest between the managers of the transferor and transferee departments.
Significance of Transfer Pricing
Transfer price is significant from the point of view of departments. However, it does not affect the company’s overall profitability because the transfer price neutralises the effect of profits generated by the transferor department by cost increase for the transferee department.
But the transfer price used shows the efficiency of the transferor department for the generation of profits and also the efficiency of the manager of the transferee department for cost-effectiveness.
If the transfer is at cost, then the efficiency of the transferor and the transferee department managers cannot be evaluated. The manager of the transferor department will always be concerned about transfer pricing, which includes costs and higher profits.
On the other hand, the manager of the transfer department will be interested in transferring products at cost. Therefore the fixing of transfer pricing is a key issue and is important in the company’s interest to motivate the managers.