Q.

1 a) Transfer Pricing is not an

Accounting
tool. Comment with
illustrations.
b) Market Price is ideal transfer price
even
in
limited markets. Comment.
Q.2. What are the objectives of transfer
pricing? What are the different
methods
to arrive at transfer price?
Discuss the appropriateness of each
method. Explain with example.

Q.3. When are the Market based Transfer

Prices most appropriate? How do we
deal
with
the condition of
Limited Market, situation of excess /
shortage of capacity?

transfer price is the price one subunit

charges for a product or service supplied
to another unit of the same organization.
Intermediate products are the products
transferred between subunits of an
organization.

 When

the SBUs of a company buys and

sells the products from/ to one another
the following two aspects should be
looked into

Sourcing : (should the company make the product

or outsource the requirement)

Transfer price: (the price that the buying unit

should pay to the selling unit)

 Proper

distribution of revenue between profit

centres.
Providing relevant information to the profit
centers regarding the trade-off between costs
and revenues of the company.
Inducing goal-congruent decisions i.e.,
decisions that improve the profits of the
business units and also improve the profits of
the company.
Helping to measure the economic
performance of the profit centres
Minimizing tax liability

 Fundamental

principle is that transfer

pricing should be similar to the price that
would be charged if the product were to
be sold to outside vendors or purchased
from outside vendors.

 Competent

people
Good organizational atmosphere
Details of market prices
Freedom to source
Availability of information
Scope for negotiation

 Limited

markets
Excess or shortage of capacity in the
industry
Sourcing constraints

1. The existence of internal capacity might limit

the development of the external sales.

2. If the company is the sole producer of a
differentiated product, no outside source
exists.
3. If the company has invested significantly by
incurring fixed costs, it is unlikely to use
outside source unless the outside selling
price approaches the companys variable
cost.

Both the following situations are not allowed

by the company as it may not optimise the
profits:
Selling SBU of the company sells the product in

the outside market because it has excess, while

the buying SBU buys the same product from the
market
Buying SBU cannot obtain the product from

outside while the selling SBU is selling the same

product outside

 The

following criteria should be used to

evaluate the methods for calculating
transfer price:
1. Goal congruence
2. Rationality
3. Autonomy
4. Performance evaluation

Market based transfer prices

Competitive price
Cost based transfer prices

Profit sharing
Two sets of prices

These conditions should be satisfied if market

based transfer price has to be adopted:
1. This method will induce goal congruence,
provided the following conditions exist.
2. SBU managers should be competent, i.e. they
are interested in short run as well as long run
performances
3. Managers should perceive TPs as just and be
interested in profitability as a goal.
4. Freedom to source the product from outside
as well as sell the product outside should be
permitted.

The fundamental principle in determining the

transfer price is that the transfer price should be
the same as the price that would be charged if the
product were sold to outside customers or
purchased from the outside vendors.
6. Market price represents opportunity cost to the
seller (and also to the company)of selling the
product inside
7. Managers ought to have full information about the
available alternatives, relevant costs and revenues
of each.
8. There must be smooth negotiation mechanism
between the SBUs

 Published

market prices
Market price set by bids
If the production profit center sells the
similar product in outside markets
If the buying profit center buys the
similar product in outside markets

Advantages: BU managers can operate as

independent profit centres. Tax and custom
authorities favour this method as it is more
transparent.
Practice: May not be possible if there is no
competitive market. Prices may also vary
from market to market.

 Cost

based pricing method: based on the

cost of the goods or services. The cost
based approach could be based on :
a. actual costs
b. standard costs
c. variable costs

 Negotiated

pricing method: Freely

negotiate a mutually agreeable price.
Advantages: since each unit is responsible
for its own performance, it will encourage
cost minimization.
Tax authorities have reservations about
this method, because companies may
manipulate to minimize their tax liability

Factors

Market based

Achieves Goal Congruence

Yes, if markets are

competitive

Useful for evaluating performance

Yes, if markets are

competitive

Motivates manager's performance

Preserves BU's autonomy

Yes
Yes, if markets are
competitive

Other factors

No market may exist

Cost based

Negotiated

Often, but not always

Difficult, unless
transfer price excceds
full cost
Yes, if based on
budgeted cost

YES

YES
YES

No it is rule based
YES
Useful for
determining full cost, Bragaining may
easy to implement
take time

 In

case of integrated firms, some fixed

costs and profits may be included in the
internal purchase price may not be known
to the profit centre that ultimately sells to
the outside customer.

 Charging

for the product twice . First,

based on the variable cost incurred on
pricing it. Second, fixed costs that are
incurred for special facilities used for
production are included. Sum of the two
charges constitute the transfer price for the
product.

 Product

is transferred to the marketing unit

at the standard variable cost. After the
products are sold, the business units share
the profits earned.
It may lead to disagreements over the way
profit is divided between the two profit
centers.

 Revenue

is credited to the manufacturing

unit at the market sales price and the
buying unit is charged for the total
standard costs. The difference between
the two prices are charged to the corporate
account.