Transfer pricing is a mechanism that allows the allocation of revenues and costs to the centers which provide products and services and consumers of both services and goods. The transfer of services and goods between one business center to another within the same organization is often referred to as ‘intra-company transactions. There are various kinds of transfer pricing methods to calculate that we will discuss in the write-up.
Different Types of Transfer Pricing Methods
The mechanism for determining transfer prices can be classified into the following methods:
1) Cost-Based Transfer Pricing
This method can be used in the following situations:
- These are the inability to obtain the market price of products produced by a commercial company, e.g., semi-finished goods, specialized products, etc.
- Challenges confront the determination of the market price of a particular product.
- Secrets must be maintained for the products that are manufactured. It is very important types of transfer pricing method.
Advantages of Cost-Based Transfer Pricing
The use of cost-based transfer pricing methods has these advantages:
1) The cost data is accessible under the accounting system used by MNCs.
2) Cost-based price of the transfer is in line with the United States Generally Accepted Accounting Principles (USGAAP) for the inventory and income determinations valuation.
3) This approach encourages directors from foreign subsidiary companies to increase the impact on their divisions, subject to certain conditions.
- If the total absorption cost exceeds the variables.
- If there is an additional capacity to process the orders received.
Disadvantages of Cost-Based Transfer Pricing
Cost-based transfer pricing has the following drawbacks:
- Inconsistencies prevalent within the seller (seller) division result in transfer onto the transféree (buyer) department. There isn’t any incentive to control costs. This problem can be avoided by using the standard cost.
- All divisions are classified as cost centers, not profit centers. Thus, ROI or RI is not used to evaluate performance.
2) Market-Based Transfer Pricing Method
The cost-based transfer pricing methods only treat different divisions as separate or profit centers in assessing efficiency. In the market-based transfer pricing model, goods and services transfer at the market price. When market forces are in play, there is a factor of competition. The vendor of products or services is required to guarantee the efficiency of the available items.
There is no reason to offer customers the most expensive products and services. Under these circumstances, markets determine prices, i.e., supply and demand position, especially over the long run. Therefore, the profit earned from the selling division will be the real measure of the division’s effectiveness. If an organization does not trade externally, and the market prices aren’t easily accessible, prices for market transactions are formulated using market reports.
But, market reports are not accurate indicators of the current prices. Thus, assessing the efficiency of a business using the profit it earns by transferring products and services at a cost calculated in this manner is only sometimes a good idea. The possibility of a division being regarded as efficient but not efficient, and vice versa, can’t be eliminated.
Advantages of Market-Based Transfer Pricing Methods
The main benefits of market-based transfer prices are:
1) The market-based transfer pricing techniques show the entry of goods into the marketplace, i.e., in the market open. This will ensure the following:
- Calculation of the profitability by the retailer in a proper and appropriate method.
- An actual measurement of its effectiveness.
- High quality of the decision-making process.
2) The profit of a division selling under this approach is calculated using the factors (market forces) and is not affected by internal elements of the organization. Thus, the chances of subjectivity creeping into is not significant.
3) From the perspective of the transferor, as well as the perspective of the transferee, it is preferred to use the market price reduced or market price lower savings.
Disadvantages of Market-Based Transfer Pricing
Transfer pricing methods based on market data that has their negatives, too. They are like:
- Collecting data to market prices can be a complicated task. If the products are made to supply only a few customers, market prices might not be available.
- Due to the forces that cause inflation, the market prices for items and services can fluctuate. Due to the frequent fluctuations in market prices, applying a transfer pricing based on market prices takes a bit of work.
- The fundamental premise behind this strategy is to decrease the profit derived from inter-divisional division. Theoretically, the method may seem reasonable; in reality, it could not be practical.
- Information on prices gathered from the market includes cost factors like packing costs, charges relating to distribution and selling, and so on. There is a possibility that distortion could be introduced while applying this method. The transfer of goods or services doesn’t cause these.
- This method of valuation of stocks is performed at the market price. This means that it is necessary to make adjustments to the profit not made in the case of stores that have been closed.
3) Negotiated Transfer Pricing
This is the third type of Transfer Pricing Methods. Each division can negotiate with external entities and sign a contract with outsiders if the results are stable. This process allows the company to decide the price of products and services in discussions held between the buying and selling divisions. This kind of approach helps to inculcate professionalism within the managers of divisions. However, when an agreement is solely to benefit commercial reasons, that division is at risk; and the company’s profits, in general, may be affected.
To avoid this situation, the top management might consider imposing some limitations on trading with outsiders. There are some fundamental points to be considered to ensure the effectiveness of the intra-company transfer pricing system:
- The prices of all products and services set through negotiations between both sections.
- Both divisional heads can suply with all the information they need for other markets or sources of purchasing/selling the products and services.
- Both Divisional Heads (buyers and sellers) should be able to negotiate in a way acceptable to the outside entities.
The formulation of policies related to transfer pricing within the company and the administration of it is the primary task for the management at the highest level. Any dispute between both divisions of the company in this area should be reported to top management for intervention. Respect for the principles of “Management by Exception” and according to prioritization of the company’s general objectives should be a priority in such situations.
Advantages of Negotiated Transfer Pricing Methods
The method of negotiating transfer pricing has the following advantages:
- The autonomy of the various divisions is preserved under this system.
- Disputes regarding cost-price are eliminated.
- When it comes to price negotiation, the issues facing divisions and a mutually acceptable solution get through understanding each other, which benefits the company.
Disadvantages of Negotiated Transfer Pricing
The following flaws afflict the negotiated transfer price that is also part of Transfer Pricing Methods:
- The final price determination is based on the negotiation skills of the negotiators.
- If there is lower capacity utilization in the selling division, the buying division is more likely to profit from the situation and attempt to lower prices.
- There could be variations in the relative performance of the respective divisions.
- Negotiations are long-winded; lots of time is required to conclude.
- An unsuccessful negotiation can lead to conflict between negotiators.
4) Dual Transfer Pricing
The dual transfer pricing method and multiple transfer pricing methods, as described above, can be used. One division (e.g., the seller) could choose the market-based pricing method, and the other (e.g., buyers) might prefer the cost-based pricing method.
Advantages of Dual Transfer Pricing
This method has an advantage over other approaches to determining transfer prices due to the following reasons:
- It helps in achieving the goal alignment of the company. Because both divisions can choose their ways of determining the price for transfer and negotiating transfer pricing, they act in the company’s best interests.
- The rates determined are affordable for both divisions.
- Measurement of the performance of the divisions by the top levels is straightforward and fair using this system.
Disadvantages of Dual Transfer Pricing Methods
The disadvantages of dual transfer pricing include the following:
- This is an intricate one.
- Certain adjustments must be made at a central level regarding the timely reconciliation of accounts to ensure that profit duplication doesn’t occur.
- Certain authorities believe that the figures derived using this method could be erroneous.