MCOMC303: Management Accounting

MASTER OF COMMERCE
SEMESTER 3

MCOMC303
MANAGEMENT ACCOUNTING
Unit: 10 - Transfer Pricing 1
MCOMC303: Management Accounting

Unit - 10
Transfer Pricing

Unit: 10 - Transfer Pricing 2

MCOMC303: Management Accounting

TABLE OF CONTENTS

SL Fig No / Table SAQ /

Topic Page No
No / Graph Activity

1 Introduction - -
4
1.1 Learning Objectives - -

2 Transfer pricing and Corporate Policy - - 5

3 Criteria for determining Transfer pricing - 1 6

4 Meaning and objectives of Transfer pricing - - 7-8

5 Methods of Transfer pricing - -

5.1 Market price - - 9-17
5.2 Cost based - 2

6 Transfer pricing practices - - 18

7 Multi-national Transfer pricing - 3 19-20

8 Summary - - 21-22

9 Glossary - - 23

10 Case study - - 24

11 Terminal Questions - - 25

12 Key Answers - -
12.1 Self-Assessment Questions - - 26-29
12.2 Terminal Questions - -

13 References - - 30

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1. INTRODUCTION
Large companies are often organized into different divisions to ensure effective control. In such
companies, where profit or investment centres are established, there is usually a transfer of goods or
services between divisions. This leads to the issue of determining the price for these internal
transfers, known as transfer pricing. When one division provides its finished output as input to
another division, the question of transfer pricing arises.

Transfer pricing refers to the price at which one division charges another for its output. Since this is
an internal transfer rather than an external sale, the transfer price differs from the normal market
price.

The price set for inter-divisional transfers serves as revenue for the supplying division and as a cost
for the receiving division. Consequently, this price influences the profit margins of both divisions.

One division's benefit (revenue) can come at the expense of the other division, impacting the financial
performance of both. Therefore, transfer pricing should be impartial and fair, ensuring equitable
treatment for all divisions within the company.

1.1. Learning Objectives

 Discuss the concept of Transfer pricing and
corporate policy.
 Examine the criteria for determining Transfer
pricing.
 Explain the meaning and objectives of Transfer
pricing.
 Analyse the various methods of Transfer pricing.
 Evaluate the various Transfer pricing practices of companies.

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2. TRANSFER PRICING AND CORPORATE POLICY

The introduction and operation of an effective transfer pricing system in organizations are
intertwined with major aspects of corporate policy, including (1) divisional autonomy, (2) transfer
pricing, and (3) performance evaluation. These aspects are key components of corporate control.
Most large organizations are structured into divisions, where divisional managers do not have
complete autonomy and must report periodically to the headquarters. Corporate policy may dictate:
a) the level of detail in these reports,
b) the accountability for decisions and actions,
c) the frequency with which divisional managers' decisions are overruled, among other factors.

The headquarters closely monitors aspects that affect other divisions' operations, such as the quantity
of output transferred between divisions and the transfer price at which these transfers occur.

In addition to control considerations, the headquarters must establish policies for evaluating
divisional performance. This evaluation is crucial for determining rewards and penalties for
divisional managers, based on observable and objective measures such as sales, profits, cost
reductions, innovation, improvements, and growth.

In divisionalized firms, corporate policy determination involves two levels of decision-making. First,
the headquarters sets overall performance evaluation and corporate control policies. Second, it
establishes enterprise-level policies related to discretionary controls, such as physical outputs and
pricing.

Divisional managers, who oversee enterprise-level variables, aim to maximize their benefits, which
are influenced by the evaluation criteria set by the headquarters. These outcomes depend on
corporate control policies and environmental factors. Environmental factors such as market
conditions, competition, pricing, and taxation are external to the enterprise. Many of these variables
are uncertain, forcing divisional managers to make decisions under uncertainty. It is in this context
of establishing corporate policies for evaluation and control that transfer pricing and its implications
for performance evaluation and corporate control must be considered.

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3. CRITERIA FOR DETERMINING TRANSFER PRICING

It is advisable to establish certain criteria before determining the transfer price. These criteria may
include:
1. The transfer price should facilitate the accurate measurement of divisional performance.
2. The transfer price should incentivize divisional managers to maximize their division's
profitability and make decisions that benefit the organization.
3. The transfer price should maintain divisional autonomy and authority.
4. The transfer price should promote goal congruence, meaning that the divisional managers'
objectives align with the overall company's objectives.
5. The transfer pricing system should prevent international groups from manipulating transfer
prices between countries to minimize their overall tax burden.

SELF-ASSESSMENT QUESTIONS – 1

Fill in the blanks:

1 Which of the following is NOT a criterion for determining transfer pricing?
A) Accurate measurement of divisional performance
B) Incentivizing divisional managers to maximize profitability
C) Ensuring divisional autonomy and authority
D) Reducing the overall cost of production for each division
2 What is the primary objective of maintaining divisional autonomy in the context of transfer
pricing?
A) To increase competition between divisions
B) To allow divisional managers to make decisions that align with the best interest of the
organization as a whole
C) To minimize tax burden internationally
D) To standardize pricing across all divisions
3 The transfer pricing system should promote __________, ensuring that the objectives of divisional
managers align with the overall goals of the company.
4 The transfer pricing system should check international groups that manipulate transfer prices
between countries to minimize their overall tax burden. True/False.

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4. MEANING AND OBJECTIVES OF TRANSFER PRICING

Meaning:
Transfer pricing refers to the methods used to set prices for the exchange of goods or services
between related enterprises or companies. It improves pricing accuracy, enhances efficiency, and
simplifies accounting processes.

By streamlining processes and methods, transfer pricing also reduces manpower costs. It contributes
to higher profitability and supports strategic business operations.

Understanding Transfer Pricing

Transfer pricing involves determining markups based on the costs incurred by a business, such as
transportation, packaging, freight, insurance, and applicable taxes or customs charges.

Typically, transfer pricing arrangements exist between related enterprises, such as holding and
subsidiary companies. These arrangements specify the transfer price for the sale or purchase of goods
between a holding company and its subsidiaries.

The arrangement can involve two or more subsidiaries of the parent company or different companies
within a group. For instance, a parent company might manufacture cars, handling the assembly and
finishing work, while two wholly owned subsidiaries produce components like brake linings. Transfer
pricing helps establish the pricing for these components between the parent company and its
subsidiaries.

Transfer pricing maintains a market for goods produced by a subsidiary, ensuring steady profit
margins. It also secures a reliable supply of raw materials or components for the parent company,
facilitating uninterrupted production. The transfer prices are generally close to the fair market value
of similar goods in the market.

Since transfer pricing occurs between related enterprises, selling goods below or above market price
is not beneficial for either entity or the group. Doing so could result in an uneven distribution of
profits among the entities within the group.

Objectives of Transfer pricing:

The main objectives of intra-company transfer pricing is explained below:

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i) Emphasis on Profits:
Intra-company transfer pricing aims to ensure that each division or subsidiary within a company is
evaluated based on its profitability. By setting transfer prices for goods or services exchanged
between divisions, the company can track the financial performance of each unit accurately. This
allows the company to identify which divisions are most profitable, encouraging managers to focus
on maximizing profits. Additionally, transfer pricing can help in shifting profits to lower-tax
jurisdictions, optimizing the company’s overall tax burden, provided it adheres to relevant laws and
regulations.

ii) Maximum Utilisation of Plant Capacity:

Another key objective of intra-company transfer pricing is to promote the maximum utilization of
plant capacity across the company. By setting appropriate transfer prices, the company can ensure
that each division operates at optimal capacity, avoiding underutilization or overextension of
resources. This objective ensures that all production facilities are used efficiently, reducing idle time
and increasing overall productivity. It also helps in balancing workloads between different units,
leading to cost savings and better resource management.

iii) Optimise Allocation of Financial Resources:

Intra-company transfer pricing also seeks to optimize the allocation of financial resources within the
company. By accurately pricing the internal transfer of goods and services, the company can allocate
resources more effectively among its divisions. This objective ensures that capital and other financial
resources are directed to areas where they will yield the highest return. It helps in avoiding
unnecessary expenditures and ensures that each division has the resources it needs to meet its
operational and strategic goals. Moreover, it enables better investment decisions and financial
planning at the corporate level, contributing to the overall financial health of the organization.

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5. METHODS OF TRANSFER PRICING

In practice, several methods are employed for determining transfer pricing, but there are two
fundamental approaches: (i) Market-based and (ii) Cost-based. Let's briefly discuss them:

5.1. Market Price

The market price is the most widely used method for determining transfer pricing because it is
generally fair for both the supplying and buying divisions. It is straightforward, as the price can easily
be found in the open market when there is a well-established market for the goods or services being
transferred. The transfer price can be set based on the market price, which should serve as the ceiling
for the transfer price. When divisions have the option to buy or sell in the open market, they may
prefer to trade with a sister division. Recording transferred goods at market price ensures that
divisional performances more accurately reflect their true economic contribution to the company’s
total profits.

However, there may be situations where deviations from market-based transfer pricing occur, such
as:
 When the products involved are highly specialized and lack a ready market, making market price
determination challenging.
 When it is necessary to leverage economies of scale in the production of certain goods or
services.
 When resources need to be reallocated from low-priority to high-priority divisions.
 When tax considerations are involved.

Market-based transfer pricing is favoured for its simplicity, ease of understanding, minimal
complications in performance evaluation, reduction of conflicts between divisions, and consistency
with external market conditions.

Illustrations 1:
ABC Ltd. manufactures a product that is created through a series of blending operations.
The finished product is packaged in glass containers made by the company and then packed in
attractive boxes. The company is divided into two independent divisions: one for the manufacture of
the final product and another for the manufacture of glass containers. The product manufacturing
division can source all its container requirements from the container manufacturing division. The

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General Manager of the container manufacturing division has obtained the following quotations from
external suppliers for the provision of empty containers:

No. of Empty Containers Total Purchase Value (Rs.)

10,00,000 18,00,000

14,00,000 26,00,000

A cost analysis of the container manufacturing division for producing empty containers reveals the
following production costs:

No. of Empty Containers Total Cost (Rs.)

10,00,000 13,00,000

14,00,000 18,00,000

The production cost and sales value of the final product marketed by the product manufacturing
division are as follows:

Volume (Containers of Total Cost of Final Product (Excluding Sales Value of Final Product
Final Product) Cost of Empty Containers) (Rs.) (Packed in Containers) (Rs.)

10,00,000 80,00,000 1,15,00,000

14,00,000 1,15,00,000 1,60,00,000

There has been considerable debate at the corporate level regarding the appropriate transfer price
for transferring empty containers from the container manufacturing division to the product
manufacturing division. This issue is particularly significant because a large portion of the Divisional
General Manager's salary is based on an incentive bonus tied to profit center results.

As the corporate management accountant tasked with defining the appropriate transfer prices for the
supply of empty containers by the container manufacturing division to the product manufacturing
division, you are required to show the profitability for the two volume levels of 10,00,000 and
14,00,000 containers using (i) the market price and (ii) a shared profit based on the costs involved
for determining transfer prices.

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The profitability position should be provided separately for the two divisions and the company as a
whole under each method. Also, discuss the impact of these methods on the profitability of the two
divisions.

Solution:
Statement showing profitability of two divisions at two different levels of output using different
transfer prices

No. of Containers 10,00,000 14,00,000

Sales Value (Final Product) (A) (A)
1,15,00,000 1,60,00,000
Less: Costs
Product Manufacturing Division 80,00,000 1,15,00,000
Container Manufacturing Division 13,00,000 18,00,000
Total Costs: (B) 93,00,000 1,33,00,000
Profit: (A) - (B) 22,00,000 27,00,000
Profit Pro-rated to Container Mfg. Division and Product Mfg.
Division
Share of Container Mfg. Division: 22,00,000 × 3,07,527
13,00,000/93,00,000
27,00,000 × 18,00,000/1,33,00,000 3,65,414
Balance Profit for Product Mfg. Division 18,92,473 23,34,586
Total Profit 22,00,000 27,00,000

Transfer Prices of Containers 10,00,000 14,00,000

Costs 13,00,000 18,00,000

Profit (as computed above) 3,07,527 3,65,414

Total Price 16,07,527 21,65,414

Transfer Price per Container Rs. 1.607 Rs. 1.546

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Profitability Based on Market Price

No. of Containers 10,00,000 14,00,000

Container Mfg. Division
Market Price 18,00,000 26,00,000
Less: Cost 13,00,000 18,00,000
Profit (i) 5,00,000 8,00,000
Product Mfg. Division
Sales 1,15,00,000 1,60,00,000
Less: Container Cost 18,00,000 26,00,000
Product Cost 80,00,000 1,15,00,000
Profit (ii) 17,00,000 19,00,000
Total Profit: (i) + (ii) 22,00,000 27,00,000

Profit Based on Costs (Rs.) and Market Price (Rs.)

Production Level Container Mfg. Product Mfg. Container Mfg. Product Mfg.
Div. Div. Div. Div.
10,00,000 3.08 18.92 5.00 17.00
Containers
14,00,000 3.65 23.35 8.00 19.00
Containers
Observations:
1. The market price method provides better profitability for the Container Manufacturing Division
at both production levels.
2. The market price method results in lower profitability for the Product Manufacturing Division
compared to the Container Manufacturing Division.
3. Under the cost-based method, there is better profit at the lower production level in the
Container Manufacturing Division. However, in the Product Manufacturing Division, the
14,00,000 production level yields higher profit. Conversely, in the market price method, the
situation is reversed.

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5.2. Cost-Based
When external markets do not exist or are inaccessible, or when accurate information about market
prices is unavailable, cost-based transfer pricing may be used. The cost-based methods include:

I. Variable Cost: This method considers only the variable production costs, such as direct
material, direct labour, and variable factory overhead, excluding fixed costs. It is useful when
the selling division is operating below capacity, although it may be less favourable for the
selling division manager as it does not provide a profit margin.
II. Actual Cost: This method includes the total or full cost of production per unit. It is simple and
convenient since the necessary information is available in the accounting records. However,
the selling division does not earn a profit, and the buying division benefits from a price lower
than the market price. It is not ideal for profit center analysis.
III. Cost Plus Normal Mark-up: This method adds a profit margin or normal mark-up to the cost
per unit. The mark-up may be set by company management or based on what competing firms
might reasonably expect to earn. The percentage of the mark-up, however, can be arbitrary
and subject to debate.
IV. Standard Cost: Standard cost, also known as "engineered cost," is a predetermined cost and is
practical and useful as a transfer price. It encourages efficiency in the selling division by not
passing inefficiencies onto the buying division. The use of standard cost also reduces risk for
the buyer.
V. Opportunity Cost: When determining transfer prices based on market price or cost is difficult,
opportunity cost may be used. This method is also relevant when the supplier division is a
monopoly producer, or the user division is a monopoly consumer. The transfer price is set at
a level equal to the opportunity cost of the supplying and using divisions. It identifies the
minimum price the selling division is willing to accept and the maximum price the buying
division is willing to pay.

For the selling division, the opportunity cost is the higher of:
 The external sales value of the transferred product.
 The differential production cost for the transferred product.

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For the buying division, the opportunity cost is the lower of:
 The price required to purchase from the open market.
 The profit that would be lost if the transferred unit could not be obtained at an economical price.

Ideally, the opportunity cost for the selling division should be lower than that for the buying division
to benefit the company. However, divisions may overstate or understate their opportunity costs to
influence the transfer price in their Favor, necessitating central management intervention to adjust.

Illustration 2:
XYZ Corporation Ltd. is a leading manufacturer of a popular electronic gadget. The company has two
divisions - Fabrication and Final Assembly. The output from the Fabrication division is transferred to
the Final Assembly division for further processing and assembly before being sold to customers as a
complete product.

The company's records show that the variable cost per unit for the Fabrication and Final Assembly
divisions are Rs. 300 and Rs. 350, respectively. The fixed cost for the Fabrication division is Rs. 20,000,
and for the Final Assembly division, it is Rs. 15,000. The product's variable cost per unit in the
Fabrication division is Rs. 450, and the total output is 120 units, which are sold to customers upon
completion at Rs. 2,500 per unit.

If the Fabrication division decides to charge its transfers to the Final Assembly division at cost plus
125%, what will be XYZ's overall profit and the profits of its two divisions?

Solution
XYZ Corporation Ltd.'s overall profit and divisional profits using cost-based transfer pricing method

Items of Expenses and Revenue Divisions Total Revenue, Expenses, and

Income of the Company
Fabrication Final Assembly
A. Revenue 1,26,000 3,00,000
125% of cost, i.e., 125% of (B) for Fabrication
division, and the Market price for Final Assembly
division
B. Expenses
1. Product Variable Cost (Rs. 450 x 120 units) 54,000 54,000

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2. Transferred Cost 1,26,000

3. Division Variable Cost 36,000 42,000
4. Division Fixed Cost 20,000 15,000
Total Expenses (1+2+3+4) 1,10,000 1,83,000
Operating Income (A - B) 16,000 1,17,000

Notes:
1. Products passing through the Final Assembly division are the final products sold to external
customers at Rs. 2,500 per unit. Hence, the company’s total revenue equals the revenue of the
Final Assembly division, i.e., 120 units @ Rs. 2,500 per unit (or Rs. 3,00,000).
2. The operating income of the two divisions combined represents the operating income of the
company. The Fabrication division's income is Rs. 16,000, while the Final Assembly division's
income is Rs. 1,17,000, resulting in a total company income of Rs. 1,33,000.

Other Methods of Determining Transfer Price:

1. Negotiated Prices: Transfer prices may also be determined through negotiations between the
selling and buying divisions, resulting in a price that falls between market-based and cost-based
prices. This method allows the seller and buyer to operate as though they were independent
companies. Negotiated prices can benefit the company by avoiding mistrust and undesirable
bargaining among divisional managers, supporting goal congruence, autonomy, and accurate
performance evaluation. However, this method can be time-consuming and may depend on the
managers' negotiation skills. One manager might exploit private information, leading to an
inaccurate price.

Illustration 3:
PQR Enterprises Ltd. is a renowned manufacturer of a specialized home appliance. The company
operates two divisions - Component Fabrication and Final Assembly. The output from the Component
Fabrication division is transferred to the Final Assembly division for further processing and assembly
before being sold to customers as a complete product.

If all other factors remain the same as in the previous example, the two divisions have agreed to set
the transfer price at Rs. 1,300 per unit for the Component Fabrication division's transfers to the Final

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MCOMC303: Management Accounting

Assembly division. What will be the profits of the two divisions compared to the overall profit of the
company?

Solution
Computation of profit for PQR Enterprises Ltd. and its two divisions under negotiated pricing method

Items of Expenses & Revenue Divisions Total Revenue, Expenses, and

Income of the Company
Component Final Assembly
Fabrication
A. Revenue: 1,56,000 3,00,000
Component Fabrication - 120 units @
Rs. 1,300 per unit
Final Assembly - 120 units @ Rs. 2,500
per unit
B. Expenses:
1. Product Variable Cost 54,000 -
2. Transferred Cost 1,56,000
3. Division Variable Cost 36,000 42,000
4. Division Fixed Cost 20,000 15,000
Total Expenses (1+2+3+4) 1,10,000 2,13,000
Operating Income (A - B) 46,000 87,000

Notes:
1. The products passing through the Final Assembly division are the final products sold to external
customers at Rs. 2,500 per unit. Hence, the company’s total revenue equals the revenue of the
Final Assembly division, i.e., 120 units @ Rs. 2,500 per unit (or Rs. 3,00,000).
2. The operating income of the two divisions combined represents the operating income of the
company. The Component Fabrication division's income is Rs. 46,000, while the Final Assembly
division's income is Rs. 87,000, resulting in a total company income of Rs. 1,33,000.

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2. Dual Prices: Also known as "two-way prices," this method credits the selling division with one
price (e.g., cost plus profit margin) while charging the buying division a different price (e.g.,
equal to variable cost). The difference between these transfer prices is accounted for centrally.
Dual pricing motivates the selling division by providing a profit margin while offering a more
appropriate price for the buying division. Although dual pricing can create a divergence between
segment profits and overall company profits, this issue can usually be resolved in the divisions'
best interests.

SELF-ASSESSMENT QUESTIONS – 2

Fill in the blanks:

5 Which of the following is a key objective of transfer pricing?
a) To increase the cost of production for the parent company
b) To ensure that all divisions operate at a loss
c) To optimize the allocation of financial resources
d) To eliminate the need for financial reporting
6 Which method of transfer pricing is most suitable when there is a well-established market for
the goods being transferred?
a) Cost-based pricing
b) Dual pricing
c) Market-based pricing
d) Negotiated pricing
7 Transfer pricing refers to the methods used to set prices for the exchange of goods or services
between __________ enterprises or companies.
8 One of the objectives of transfer pricing is to ensure __________ utilization of plant capacity within
the company.
9 The __________ method of transfer pricing includes only the variable production costs, excluding
fixed costs.
10 Transfer pricing is only relevant for companies that operate in a single country. True/False
11 Market-based transfer pricing is considered fair and reasonable for both the supplying and
buying divisions. True/False
12 Negotiated transfer pricing requires less management effort and time compared to other
methods. True/False

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6. TRANSFER PRICING PRACTICES

There is extensive documentation on the transfer pricing policies employed by companies worldwide.
These studies have examined various aspects of transfer pricing, including (a) its role as a key
component of companies' reporting and control systems, (b) its impact on intra-corporate conflicts,
(c) differences in transfer pricing policies across different regions, and (d) environmental constraints
affecting the use of transfer prices.

Summary of Transfer Pricing Practices:

1. Companies view transfer pricing not merely as an accounting task but as a critical tool in
formulating policies aimed at achieving corporate objectives.
2. Transfer pricing often serves as a significant source of internal political conflict within
organizations, regardless of the method used. However, different methods can either increase
or decrease the likelihood of such conflicts.
3. Companies utilize a variety of transfer pricing methods, with market-based prices or
modifications of market prices being the most commonly used.
4. While many companies consider transfer pricing as a policy variable, it is typically not the
primary or most significant policy variable.
5. International companies deliberately manipulate transfer prices as a means to maximize
corporate goals. A clear example of this is the strategic transfer of profits from subsidiaries to
parent companies or other group entities through transfer pricing policies related to the supply
of capital equipment or inputs by multinational corporations.

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7. MULTI-NATIONAL TRANSFER PRICING

In the discussions above, we have examined transfer pricing policies practices. However, in
multinational companies, other factors often take precedence. These companies use transfer pricing
strategically to minimize global income taxes, import duties, and tariffs. For instance, a company like
Nike might prefer to record profits in a country with a lower corporate tax rate, such as 28%, rather
than in a country with a higher rate, such as 35%. If a division in a high-tax country produces a
component for a division in a low-tax country, setting a low transfer price allows the company to shift
most of the profit to the low-tax country, thus reducing overall tax liability. Conversely, if items are
produced in a low-tax country and transferred to a high-tax country, setting a higher transfer price
helps in minimizing taxes.

Import duties can also impact the tax benefits of transfer pricing. Many countries impose import
duties based on the price of the item, whether purchased externally or transferred internally.
Consequently, lower transfer prices generally result in lower import duties.

For example, consider a populated PCB manufactured by Alcatel Ltd. in Switzerland, with an 8%
income tax rate, and transferred to a division in India, where the income tax rate is 40%. India
imposes a 20% import duty on the price of the item, and Alcatel cannot deduct this duty for tax
purposes. If the full unit cost of the PCB is Rs. 100 and the variable cost is Rs. 60, the choice between
a variable-cost or full-cost transfer price becomes significant. By transferring the PCB at Rs. 100
instead of Rs. 60, the company can achieve a net saving of Rs. 4.80 per unit. This is because the Swiss
division's income is Rs. 40 higher, leading to an additional income tax of Rs. 3.20, while the Indian
division's income is Rs. 40 lower, reducing its income tax by Rs. 16.00. However, the Indian division
will incur an additional import duty of Rs. 8, calculated as 20% of the Rs. 40 difference in transfer
price. The net saving from this strategy is Rs. 4.80 per unit.

Additionally, transfer pricing can help multinational companies navigate financial restrictions
imposed by governments. For instance, if a country limits dividend payments to foreign owners, a
company might find it easier to repatriate cash from a foreign division through payments for
transferred products rather than through cash dividends.

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In summary, transfer pricing is more intricate in multinational companies compared to domestic ones.
These companies use transfer pricing to achieve multiple objectives, which can sometimes be at odds
with each other.

SELF-ASSESSMENT QUESTIONS – 3

Fill in the blanks:

13 Why might a multinational company choose to transfer goods at a low price from a high-tax
country to a low-tax country?
a) To increase the import duties in the low-tax country
b) To shift most of the profit to the low-tax country and reduce overall tax liability
c) To maximize the profit margin in the high-tax country
d) To comply with local financial restrictions
14 Which of the following is a potential advantage of using transfer pricing to transfer goods at a
higher price from a low-tax country to a high-tax country?
a) Lower import duties in the high-tax country
b) Reduced profit margin for the selling division
c) Increased import duties in the high-tax country
d) Higher income taxes in the selling division
15 Multinational companies often use transfer pricing to minimize worldwide income taxes,
import duties, and __________.
16 When a company transfers goods from a division in a high-income-tax-rate country to a division
in a low-income-tax-rate country, setting a low transfer price helps to __________ the taxes overall.

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8. SUMMARY

 Transfer pricing is a critical aspect of corporate policy, especially for companies with multiple
divisions or international subsidiaries. It involves setting the prices at which goods, services, or
intangible assets are transferred between different parts of the same organization. The
corporate policy on transfer pricing aims to align these internal transactions with the company’s
overall financial strategy, optimize tax obligations, and ensure that each division operates as a
profit centre. It also seeks to maintain regulatory compliance and minimize the risk of tax audits.
 When determining transfer pricing, companies consider various criteria such as market
conditions, production costs, and the economic contributions of each division involved in the
transaction. The main criteria include aligning with market prices to reflect external competition,
ensuring fairness in profit distribution, and adhering to the arm's length principle, which
mandates that the transfer price should be comparable to what independent entities would
charge in similar transactions. Regulatory requirements and tax implications also play a
significant role in the decision-making process.
 Transfer pricing refers to the pricing of goods, services, and intangibles transferred between
related entities within a multinational corporation. The primary objectives of transfer pricing
are to allocate income appropriately among the entities, ensure that each division's performance
is accurately measured, and manage tax liabilities effectively. It also aims to minimize risks
related to tax disputes and enhance the overall efficiency and profitability of the organization by
encouraging sound business practices within each division.
 Methods of Transfer Pricing: a) Market price b) Cost-based method
 Market Price Method: This method bases the transfer price on the current market price of
similar goods or services sold in an open market. It is often considered the most objective
method since it reflects actual external conditions, ensuring that the internal transactions are
comparable to those between independent parties.
 Cost-Based Method: The cost-based method sets transfer prices based on the production cost of
the goods or services, often adding a predetermined profit margin. This method is useful when
there is no comparable market price available, allowing companies to cover costs and earn a
reasonable profit while maintaining simplicity in pricing.
 Transfer pricing practices involve applying selected methods to determine transfer prices in a
way that meets both business objectives and regulatory requirements. These practices include

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analyzing market conditions, cost structures, and intercompany agreements to set prices that
reflect the economic realities of each transaction. Effective transfer pricing practices ensure that
profit distribution among divisions is fair, tax liabilities are minimized, and compliance with
international tax laws is maintained, reducing the risk of tax disputes.
 Multinational transfer pricing refers to the practice of setting transfer prices for transactions
between subsidiaries or divisions of a multinational corporation operating in different countries.
It is a complex area of corporate finance due to differing tax laws, regulations, and economic
environments across jurisdictions. The main objectives include optimizing global tax liabilities,
avoiding double taxation, and ensuring compliance with the transfer pricing regulations of each
country. Proper management of multinational transfer pricing is crucial for mitigating risks
associated with tax audits and penalties while ensuring the efficient global allocation of profits.

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9. GLOSSARY

Divisional The degree of independence granted to a division within a company to

- make its own decisions regarding operations, pricing, and strategy.
Autonomy

Market-Based A transfer price set based on the prevailing price for similar goods or
- services in the external market.
Price

Cost-Based Price - A transfer price determined by adding a markup to the cost of producing
the goods or services being transferred between divisions.
A transfer price agreed upon through negotiation between the buying and
Negotiated Price - selling divisions within the same company.

A market condition where a single seller dominates the market,

Monopoly - controlling the supply and price of a particular good or service without
competition.

A transfer pricing strategy where the selling division uses one price (often

Dual Price - higher) for internal transactions and another price (often lower) for
external sales.

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10. CASE STUDY

Raj Co. Ltd is the manufacturer of a certain electronic product. The company has three divisions—
A1 A2 and A3. Output of A1 is transferred to A2 and that of A2 to A3 for further processing and
assembling before they are passed on to the hands of the customer as final product. The company
reports that variable costs per unit of the product for A1 A2 and A3 are Rs. 600, Rs. 400 and Rs. 200,
respectively. The fixed costs for the three divisions are Rs. 40,000, Rs. 30,000 and Rs.20,000
respectively. The product variable cost per unit is Rs. 400 for division A1.If the total output of the
company for a certain period is 2,000 units, which are sold to the customer at Rs. 2,400 per unit, and
if division A1 decides to charge its transfers to A2 at cost plus 120% and A2 to A3 at cost plus 110%,
what is the company’s total profit and the profits of its divisions?

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11. TERMINAL QUESTIONS

1. What is the meaning of Transfer pricing?
2. Explain Market-price method of Transfer pricing.
3. Explain various Cost-based methods of Transfer pricing.
4. Explain Multi-national Transfer pricing.

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12. KEY ANSWERS

12.1. Self-Assessment Questions

1. d) Reducing the overall cost of production for each division
2. b) To allow divisional managers to make decisions that align with the best interest of the
organization as a whole
3. goal congruence
4. True
5. c) To optimize the allocation of financial resources
6. c) Market-based pricing
7. related
8. maximum
9. variable cost
10. False
11. True
12. False
13. b) To shift most of the profit to the low-tax country and reduce overall tax liability
14. c) Increased import duties in the high-tax country
15. tariffs
16. minimize

12.2. Terminal Questions

Answer 1: Transfer pricing refers to the methods used to set prices for the exchange of goods or
services between related enterprises or companies. It improves pricing accuracy, enhances efficiency,
and simplifies accounting processes. By streamlining processes and methods, transfer pricing also
reduces manpower costs. It contributes to higher profitability and supports strategic business
operations.

Understanding Transfer Pricing

Transfer pricing involves determining markups based on the costs incurred by a business, such as
transportation, packaging, freight, insurance, and applicable taxes or customs charges.

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Typically, transfer pricing arrangements exist between related enterprises, such as holding and
subsidiary companies. These arrangements specify the transfer price for the sale or purchase of goods
between a holding company and its subsidiaries.

The arrangement can involve two or more subsidiaries of the parent company or different companies
within a group. For instance, a parent company might manufacture cars, handling the assembly and
finishing work, while two wholly owned subsidiaries produce components like brake linings. Transfer
pricing helps establish the pricing for these components between the parent company and its
subsidiaries.

Answer 2: The market price is the most widely used method for determining transfer pricing because
it is generally fair for both the supplying and buying divisions. It is straightforward, as the price can
easily be found in the open market when there is a well-established market for the goods or services
being transferred. The transfer price can be set based on the market price, which should serve as the
ceiling for the transfer price. When divisions have the option to buy or sell in the open market, they
may prefer to trade with a sister division. Recording transferred goods at market price ensures that
divisional performances more accurately reflect their true economic contribution to the company’s
total profits.

However, there may be situations where deviations from market-based transfer pricing occur, such
as:
 When the products involved are highly specialized and lack a ready market, making market price
determination challenging.
 When it is necessary to leverage economies of scale in the production of certain goods or
services.
 When resources need to be reallocated from low-priority to high-priority divisions.
 When tax considerations are involved.

Market-based transfer pricing is favoured for its simplicity, ease of understanding, minimal
complications in performance evaluation, reduction of conflicts between divisions, and consistency
with external market conditions.

Answer 3: When external markets do not exist or are inaccessible, or when accurate information
about market prices is unavailable, cost-based transfer pricing may be used. The cost-based methods
include:

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2. Variable Cost: This method considers only the variable production costs, such as direct
material, direct labor, and variable factory overhead, excluding fixed costs. It is useful when the selling
division is operating below capacity, although it may be less favorable for the selling division manager
as it does not provide a profit margin.

3. Actual Cost: This method includes the total or full cost of production per unit. It is simple and
convenient since the necessary information is available in the accounting records. However, the
selling division does not earn a profit, and the buying division benefits from a price lower than the
market price. It is not ideal for profit center analysis.

4. Cost Plus Normal Mark-up: This method adds a profit margin or normal mark-up to the cost
per unit. The mark-up may be set by company management or based on what competing firms might
reasonably expect to earn. The percentage of the mark-up, however, can be arbitrary and subject to
debate.

5. Standard Cost: Standard cost, also known as "engineered cost," is a predetermined cost and is
practical and useful as a transfer price. It encourages efficiency in the selling division by not passing
inefficiencies onto the buying division. The use of standard cost also reduces risk for the buyer.

6. Opportunity Cost: When determining transfer prices based on market price or cost is difficult,
opportunity cost may be used. This method is also relevant when the supplier division is a monopoly
producer or the user division is a monopoly consumer. The transfer price is set at a level equal to the
opportunity cost of the supplying and using divisions. It identifies the minimum price the selling
division is willing to accept and the maximum price the buying division is willing to pay.

For the selling division, the opportunity cost is the higher of:
 The external sales value of the transferred product.
 The differential production cost for the transferred product.

For the buying division, the opportunity cost is the lower of:
 The price required to purchase from the open market.
 The profit that would be lost if the transferred unit could not be obtained at an economical price.

Ideally, the opportunity cost for the selling division should be lower than that for the buying division
to benefit the company. However, divisions may overstate or understate their opportunity costs to
influence the transfer price in their Favor, necessitating central management intervention to adjust

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Answer 4: pricing strategically to minimize global income taxes, import duties, and tariffs. For
instance, a company like Nike might prefer to record profits in a country with a lower corporate tax
rate, such as 28%, rather than in a country with a higher rate, such as 35%. If a division in a high-tax
country produces a component for a division in a low-tax country, setting a low transfer price allows
the company to shift most of the profit to the low-tax country, thus reducing overall tax liability.
Conversely, if items are produced in a low-tax country and transferred to a high-tax country, setting
a higher transfer price helps in minimizing taxes.

Import duties can also impact the tax benefits of transfer pricing. Many countries impose import
duties based on the price of the item, whether purchased externally or transferred internally.
Consequently, lower transfer prices generally result in lower import duties.

For example, consider a populated PCB manufactured by Alcatel Ltd. in Switzerland, with an 8%
income tax rate, and transferred to a division in India, where the income tax rate is 40%. India
imposes a 20% import duty on the price of the item, and Alcatel cannot deduct this duty for tax
purposes. If the full unit cost of the PCB is Rs. 100 and the variable cost is Rs. 60, the choice between
a variable-cost or full-cost transfer price becomes significant. By transferring the PCB at Rs. 100
instead of Rs. 60, the company can achieve a net saving of Rs. 4.80 per unit. This is because the Swiss
division's income is Rs. 40 higher, leading to an additional income tax of Rs. 3.20, while the Indian
division's income is Rs. 40 lower, reducing its income tax by Rs. 16.00. However, the Indian division
will incur an additional import duty of Rs. 8, calculated as 20% of the Rs. 40 difference in transfer
price. The net saving from this strategy is Rs. 4.80 per unit.

Additionally, transfer pricing can help multinational companies navigate financial restrictions
imposed by governments. For instance, if a country limits dividend payments to foreign owners, a
company might find it easier to repatriate cash from a foreign division through payments for
transferred products rather than through cash dividends.

In summary, transfer pricing is more intricate in multinational companies compared to domestic ones.
These companies use transfer pricing to achieve multiple objectives, which can sometimes be at odds
with each other.

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13. REFERENCES
 Horngren, Charles T., Datar, Srikant M., & Rajan, Madhav V. (2015). Cost Accounting: A
Managerial Emphasis (15th Edition). Pearson Education.
 Kaplan, Robert S., & Atkinson, Anthony A. (1998). Advanced Management Accounting (3rd
Edition). Prentice Hall.
 https://cleartax.in/glossary/transfer-pricing

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