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Transfer Pricing

Transfer Pricing
A transfer price is the price one subunit charges for a product or service supplied to another subunit of the same organization. Intermediate products are the products transferred between subunits of an organization.

Transfer Pricing
Transfer pricing should help achieve a companys strategies and goals. fit the organizations structure promote goal congruence promote a sustained high level of management effort

Transfer Pricing and E-commerce


Intra-company transfer pricing: an enterprise provides goods or services through a branch situated in a different country, using an electronic communications networ !"nternet or "ntranet#: e$ commerce, e$tailing% Inter-companies transfer pricing: two companies that are part of the same group !holding$subsidiary, subsidiary$subsidiary# and that are located in different &urisdictions enter into an e$commerce transaction directed to trade goods or services.

Transfer Pricing Trends and Focus


Trends: "ncrease of Audits in 'uropes large economies (pecific issues for emerging economies "ntangibles and cost sharing agreements !))A# 'nforcement and Advance *ricing Agreements !A*A# +ocumentation and penalties Transfer Pricing Focus: ,estructuring of business models -se of low ta. &urisdictions /ow margin and loss ma ing businesses 0utbound payments for royalties1service !intangibles# -se of international comparables

Transfer-Pricing Methods
2ar et$based transfer prices )ost$based transfer prices 3egotiated transfer prices

Market-based transfer prices


Transfer prices are based on mar et prices. 4hen there is a perfectly competitive mar et for the goods and services that are bought and sold between divisions of an organization, the transfer price should be the mar et price. The transfer price may be slightly lower than the mar et price if the selling e.penses are lower for interdivisional transfers, e.g. because there is no advertising cost for transfers between divisions. There is a problem for managers in that mar et prices may fluctuate.

Market-based transfer prices


Transferring products or services at mar et prices generally leads to optimal discussion where three conditions are satisfied The mar et for the intermediate products is perfectly competitive "nter dependencies of sub units are minimal There are no additional cost or benefits to the company as a whole from buying or selling in the e.ternal mar et , instead of transacting internally

Market-based transfer prices


Advantages
5orces selling division to be competitive with mar et conditions +oes not penalize buying division by charging a price greater than it would have to pay on the mar et

Market-based transfer prices


+isadvantages
2ay lead selling division to ignore negotiation attempts from buying division and sell directly to outside customers
)ould cause an internal shortage of materials 5orces buying division to purchase materials from the outside 0verall company profits may fall even though selling division ma es a profit

Cost-Based Pricing Methods


2anagers can develop a price based on the cost of producing the product or service
"f prices do not cover costs, the company will fail

Two pricing methods based on cost


6ross margin pricing ,eturn on assets pricing

Cost-Based Pricing Methods (contd


The Energeez Company buys parts from outside vendors and assembles them into portable solar panels. In the previous period, the company produced 14,7 ! solar panels. Total costs and unit costs incurred "ere as follo"s

#o changes in unit costs are e$pected this period. %esired profit for the period is &11!,'( . The company uses assets in producing the panels and e$pects a 14) return on those assets

!ross Margin Pricing


6ross margin
The difference between sales and the total production costs of those sales

6ross margin pricing


)ost$based pricing approach
*rice is computed using a mar up percentage based on a products total production costs

2ar up percentage
+esigned to include all costs other than those used in the computation of gross margin )omposed of selling, general, and administrative e.penses and the desired profit

!ross Margin Pricing (contd


This method can be easily applied
An accounting system often provides management with production cost data

"eturn on #ssets Pricing


7ased on earning a profit e8ual to a specified rate of return on assets employed in the operation
5ocuses on a desired minimum rate of return on assets

Also called the balance sheet approach to pricing

"eturn on #ssets Pricing (contd

Negotiated Transfer Prices


3egotiated transfer prices arise from the outcome of a bargaining process between selling and buying divisions. 4here subunits of a firm are free to negotiate the transfer price between themselves and then to decide whether to buy and sell internally or deal with e.ternal parties 2ay or may not bear any resemblance to cost or mar et data 0ften used when mar et prices are volatile ,epresent the outcome of a bargaining process between the selling and buying subunits

Negotiated Transfer Prices


Advantages Autonomy +ecentralisation 7etter information about costs and benefits 2ost appropriate where there are mar et imperfections for the intermediate product and when managers have e8ual bargaining power. To be effective, managers must understand how to use cost and revenue information. Limitations: )an lead to sub$optimal decisions Time $ consuming +ivisional profitability may be strongly influenced by the bargaining s ills and powers of the divisional managers.

Comparison of Transfer-Pricing Methods


Criteria
Achieves 6oal )ongruence -seful for 'valuating (ubunit *erformance

MarketBased
9es, when mar ets are competitive 9es, when mar ets are competitive

Cost- Based
0ften, but not always

Negotiated
9es

+ifficult unless 9es, but transfer transfer price prices are affected e.ceeds full cost by bargaining and even then is strengths of the somewhat buying and selling arbitrary divisions

Comparison of Transfer-Pricing Methods


Criteria
2otivates 2anagement 'ffort

MarketBased
9es

Cost- Based
9es, when based on budgeted costs% less incentive to control costs if transfers are based on actual costs 3o, because it is rule$based

Negotiated
9es

*reserves (ubunit 9es, when mar ets Autonomy are competitive

9es, because it is based on negotiations between subunits

Comparison of Transfer-Pricing Methods


Criteria MarketBased Cost- Based Negotiated

0ther 5actors 3o mar et may -seful for 7argaining and e.ist or mar ets determining full negotiations ta e may be cost of products% time and may need imperfect or in easy to to be reviewed distress implement repeatedly as conditions change

Transfer Pricing $trategy


Pricing of goods, services, and intangible ro ert! boug"t and sold b! o erating units or divisions of a com an! doing business #it" an affiliate in anot"er $urisdiction%

Transfer Pricing $trategy


5our arrangements for pricing goods for intra$ company transfer are as follows: :. (ales at the local manufacturing cost plus a standard mar up ;. (ales at the cost of the most efficient producer in the company plus a standard mar up <. (ales at negotiated prices =. Arms$length sales using the same prices as 8uoted to independent customers

Benefits of Transfer Pricing $trategy


:. /owering duty costs by shipping goods into high$ tariff countries at minimal transfer prices so that duty base and duty are low ;. ,educing income ta.es in high$ta. countries by overpricing goods transferred to units in such countries% profits are eliminated and shifted to low$ ta. countries <. 5acilitating dividend repatriation when dividend repatriation is curtailed by government policy by inflating prices of goods transferred

Transfer Pricing "isks


'conomic +ouble Ta.ation )ompetent Authority *rocess "ncome Ad&ustments *enalties and "nterest "nternal +efence )osts 2anagement Time (taff Attrition Advisor +efence )osts ,evenue Authority "nformation (haring

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