UNIT -6

PRINCING AND TRANSFER PRINCING

Pricing Policies

 Setting appropriate prices is one of the most difficult decisions that managers must make
on a day-to-day basis.
 Because such decisions affect the long-term survival of any profit-oriented enterprise, a
company’s long-term objectives should include a pricing policy.
 Pricing policy is one way in which companies differentiate themselves from their
competitors.
• market price–based transfer pricing policy contains the following guidelines:

• The policy sets the transfer price at a discount from the cost to acquire the item on the open market.

• The selling division may elect to transfer or to continue to sell to the outside.

ESTABLISHING A COST BASIS POLICY. A cost-based transfer pricing policy should adopt
the following rule:
i. Transfer at the differential outlay cost to the selling division (typically variable costs)
plus the opportunity cost to the company of making the internal transfers ($0 if the seller
has idle capacity;
ii. Selling price minus variable costs if the seller is operating at capacity).
Pricing Policy Objectives

1. Identifying and adhering to both short-run and long-run pricing strategies.

• Short-run pricing decisions typically have a time horizon of less than a year and include
decisions such as

(a) Pricing a one-time-only special order with no long-run implications and

(b) Adjusting product mix and output volume in a competitive market.

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Two key factors affect short-run pricing.
1. Many costs are irrelevant in short-run pricing decisions:
 Example, most of company’s costs in R&D, design, and manufacturing, marketing,
distribution, and customer service are irrelevant for the short-run pricing decision,
because these costs will not change whether co’s wins or does not win the business.
 But these costs will change in the long run and therefore will be relevant.
2. Short-run pricing is opportunistic: Prices are decreased when demand is weak and competition is
strong and increased when demand is strong and competition is weak.

Long-run pricing

 Long-run pricing is a strategic decision designed to build long-run relationships with

customers based on stable and predictable prices.
 A stable price reduces the need for continuous monitoring of prices, improves planning,
and builds long-run buyer–seller relationships.
 But to charge a stable price and earn the target long-run return, a company must, over the
long run, know and manage its costs of supplying products to customers.
 Relevant costs for long-run pricing decisions include all future fixed and variable costs.
Alternative Long-Run Pricing Approaches

• Two different approaches for pricing decisions are as follows:

1. Market-based

2. Cost-based, which is also called cost-plus

1. The market-based approach to pricing starts by asking, “Given what our customers want and
how our competitors will react to what we do, what price should we charge?”
• Based on this price, managers control costs to earn a target return on investment.
2.The cost-based approach to pricing starts by asking, “Given what it costs us to make this product, what
price should we charge that will recoup our costs and achieve a target return on investment?”

2. Maximizing profits: Maximizing profits has traditionally been the underlying objective of
any pricing policy.

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3. Maintaining or gaining market share:

Maintaining or gaining market share is closely related to pricing strategies.

To increase market share by reducing prices below cost can be economically disastrous
unless such a move is accompanied by strategies that compensate for the lost revenues.

4. Setting socially responsible prices:-Maximizing profits remains a dominant factor in price setting.
• The pricing policies of many companies now take into consideration a variety of social
concerns, including environmental factors, the influence of an aging population, legal
constraints, and ethical issues.
5. Maintaining a minimum rate of return on investment.

To maintain a minimum return on investment, an organization, when setting prices, adds a mark-
up percentage to each product’s costs of production.

This mark-up percentage is closely related to the objective of profit maximization.

6. Being customer focused.

 Taking customers’ needs into consideration when setting prices or increasing a product’s
value to customers is important for at least three reasons. These reasons are as follows:
 Sensitivity to customers is necessary to sustain sales growth.
 Customers’ acceptance is crucial to success in a competitive market.
 Prices should reflect the enhanced value that the company adds to the product or service,
which is another way of saying that prices are customer driven.
For an organization to stay in business, its selling price must

(1) Be competitive with the competition’s price,

(2) Be acceptable to customers,

(3) Recover all costs incurred in bringing the product or service to market, and

(4) Return a profit.

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External and Internal Pricing Factors

 When making and evaluating pricing decisions, managers must consider many factors.
 The external factors include demand for the product, customer needs, competition, and
quantity and quality of competing products or services.
 The internal factors include constraints caused by costs, desired return on investment,
quality and quantity of materials and labor, and allocation of scarce resources.
Target pricing

 Market-based pricing starts with a target price

 is the estimated price for a product or service that potential customers are willing to pay
 This estimate is based on an understanding of customers’ perceived value for a
product or service and how competitors will price competing products or services.
 is a pricing method designed to enhance a company’s ability to compete, especially in
markets for new or emerging products
 This understanding of customers and competitors is becoming increasingly important for
three reasons:
a. Competition from lower-cost producers is continually restraining prices.

b. Products are on the market for shorter periods of time, leaving less time and opportunity to
recover from pricing mistakes, loss of market share, and loss of profitability.

c. Customers are becoming more knowledgeable and incessantly demanding products of higher
and higher quality at lower and lower prices.

Transfer Pricing

 It is the price at which goods and services are charged and exchanged between a
company’s divisions or segments.
 Transfer prices are Intra Company charges for goods or services bought and sold between
segments of a decentralized company.
 They are an internal pricing mechanism that allows transactions between divisions or
segments of a business to be measured and accounted for.
 Transfer prices affect the revenues and costs of the divisions involved.

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  They do not affect the revenues and costs of the company as a whole.
It is not used for external pricing; it is used to set prices for transfers among a company’s
departments, divisions, or segments.

Instead of allocating support department costs to user departments, support services can be
“sold” to user departments using transfer prices.

• Top management must determine which method (allocation or transfer pricing)

produces the most useful information.
• Transfer prices are used in organizations to:
 Enhance goal congruence.
 Make performance evaluations among segments more comparable.
 Change a cost center into a pseudo-profit center.
 Ensure optimal resource allocations.
 Promote responsibility center autonomy.
 Encourage motivation and communication among responsibility center managers.
• There are three primary approaches to developing transfer prices:

(1) The price may be based on the cost of the item up to the point at which it is transferred to the
next department or process;

(2) The price may be based on market value if the item has an existing external market; or

(3) The price may be negotiated by the managers of the buying and selling divisions.
 Transfer prices for goods or services can be calculated in a number of ways, but the
following general rules are appropriate:

1. The maximum price should be no higher than the lowest market price at which the buying
segment can acquire the goods or services externally.

2. The minimum price should be no less than the sum of the selling segment’s incremental costs
associated with the goods or services plus the opportunity cost of the facilities used.
 Transfer prices may be cost based, market based, or negotiated; a dual pricing
systemcan also be used to assign different transfer prices to the selling and buying units.

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Transfer prices are set between two boundaries:

The upper price boundary is the lowest market price at which the product/service can be acquired
externally.

The lowest price boundary is the incremental cost of production or performance plus the
opportunity cost of the facilities used.
Types of Transfer Prices

1. MARKET BASED TRANSFER PRICES

• Equivalent to what is being charged in the outside market for similar goals .Therefore; it
is called the external market price.
 If there is a comparative market for the product or services being transferred internally,
using the market price as a transfer price will generally lead to the desired goal
congruence & managerial effort.
 The market price may come from published price lists for similar products or services or
it, may be the price charged by the products division to its external customers.
 The internal transfer price may be the external market price less the selling and delivery
expenses that are not incurred on internal business.
 The major drawback to market based prices is that market prices are not always available
for items transferred internally.
2. NEGOTIATED TRANSFER PRICES
 Companies heavily committed to segment autonomy often allow managers to negotiate
transfer prices. The managers may consider both costs &market prices in their
negotiations, but no policy requires them to do so.
 Supporters of negotiated transfer prices maintain that the managers involved have the
best knowledge of what the company will gain or lose by producing and transferring the
product or services, so open negotiation allows the managers to make optimal decisions.
a negotiated transfer price is used, that is, a price is reached through bargaining between the
managers of the selling and buying divisions. A negotiated transfer price is often used for internal
pricing.

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 3. Cost-Plus Transfer Price
 Cost-Plus Transfer Price A cost-plus transfer price is based on either the full cost or the
variable costs incurred by the producing division plus an agreed-on profit percentage.
 Is that cost recovery is guaranteed to the selling division.
 similar to the gross margin pricing method
 Non Market Based Transfer Pricing
Types of Transfer Prices and Related Questions of Use
 Cost-Based

1. What should be included in cost?

Variable production costs

Total variable cost

 Absorption production costs
 “Adjusted” absorption production costs

2. Should cost be actual or standard?

3. Should a profit margin for the selling division be included?

• Market-Based

1. What if there is no exact counterpart in the market?

2. What if internal sales create a cost savings (such as not having bad debts) that would not exist
in external sales?

3. What if the market price is currently depressed?

4. Which market price should be used?

• Negotiated

1. Do both parties have the ability to bargain with autonomy?

2. How will disputes be handled?

3. Are comparable product substitutes available externally?

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Negative transfer pricing system outcomes:
 Disagreement between unit managers as to how the transfer price should be set.
 Additional organizational costs and employee time
 The potential for dysfunctional behavior among organizational units and for
underutilization or overutilization of services.
 The need for year-end entries to eliminate the transfer prices.
 A means of encouraging and rewarding goal congruence by managers in decentralized
operations.
Positive transfer pricing system outcomes:
 An appropriate basis for calculating and evaluating segment performance.
 Information to make rational acquisition decisions about transfers of goods and services
between corporate divisions.
 The flexibility to respond to changes in demand or market conditions.
 A means of encouraging and rewarding goal congruence by managers in decentralized
operations.
Transfer Prices in Multinational Companies
 Multinational companies using transfer prices encounter difficulties, including
differences in

- Tax systems,

- Customs duties,

- Freight and insurance costs,

- Import/export regulations, and

- Foreign-exchange controls.
 Multinational companies must attempt to determine what transfer price would be
considered “reasonable” as if generated in an arm’s-length transaction.
 Multinational companies face an increase in transfer pricing audits by tax authorities.

Advanced pricing agreements are binding contracts with tax authorities that indicate no
adjustments or penalties will be assessed if the agreements are followed.

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Cross-Discipline Approach to Transfer Pricing

Tax

• Acts as project driver

• Ensures objectives are met

• Makes sure all tax requirements are met

• Handles notifications to tax authorities

• Provides documentation/defense
Finance

• Advises on and develops solutions for management systems

• Addresses the ability of the financial reporting system to handle implications of transfer pricing

• Provides required financial data, including segmented data and budgets

• Assists in (or takes primary responsibility for) developing and running transfer pricing models
Accounting

• Provides information on accounting systems, accounting rules, consolidation of accounts

• Administers invoicing/booking/settlement of intercompany payments

Legal

• Oversees development of intercompany legal agreements and legal pricing requirements

Information Technology

• Assists in developing software, a programming interface with the transfer pricing model, and an
internal financial system
Customs

• Assesses valuation, duty impacts, and representation and notification requirements

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Operations: Members with Global Business Experience

• Assist in determining foreign implications of transfer pricing policy

• Act as intermediaries between U.S. and foreign businesspeople

• May be structured similarly to U.S. core team

Outside Advisers

• Bring industry best practices to the internal team

• Provide access to resources around the world experienced in international tax, transfer pricing,
valuation, VAT, and customs

• Offer insight into expectations of auditors with respect to tax provision, including FAS 109, and
Sarbanes-Oxley requirements
SETTING TRANSFER PRICES
 The company uses transfer prices to transfer goods and services between divisions while
 Allowing them to retain their autonomy. The transfer price can motivate managers to act
 In the best interest of the company.
 To help explain the issues involved with transfer pricing, we will discuss four transfer
pricing scenarios:

1. No outside suppliers are available.

2. Outside suppliers are available, but the selling division is below capacity.

3. Outside suppliers are available, and the selling division is at capacity.

4. Outside suppliers are available, the selling division is below capacity, and alternative facility
uses exist.
Basic questions
 Does change in transfer price affect he total company operating profit?
 but does affect division performance

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