Quiz 15: Transfer Pricing

Business

Transfer Pricing Before elaborating on the purpose of transfer pricing, let us first understand the concept of transfer pricing or what the transfer pricing is Transfer pricing is a price that a division which is a part of a large business entity charges to another division within the same business entity while transferring services or goods. Now students should ask why it is so difficult task, especially when both divisions, the buying and the selling divisions belonging to same entity. Here students should know that the remunerations of the management executives in the buying division as well as in the selling division depend to a large extent upon the amount of profits their divisions made. Hence the executives in both the organizations would like to register as much profit as possible. It is more like milking the cow as long as it is beneficial to both the divisions. However at a certain point, equilibrium reaches. At this point, buying division as well as selling division will register a profit which will be larger than the profit, these divisions would have made when they do the transactions in the open market. If buying department can buy goods at the price which is lower than the price which is being offered by selling department, then the management of buying department would surely like to buy it from outside. This will be much more profitable proposition for them. On the other hand, if selling department is able to sale the product at a price which is higher than buying department, then surely the management of selling department will not be interested in selling the product to buying department because that will hamper their profit growth. So market price play a very balancing act for buying department as well as for selling department. Because buying department would not be able to buy the products lower than market price. In other perspective, selling department would also not be able to sale its output higher than market price. Hence market price plays the role of equilibrium and keeps in check the overgrown ambitions of both the departments. In the backdrop of this context, we can define the purpose of transfer pricing; 1. The utmost purpose of the transfer pricing issue is to fix an equilibrium price where the interest of the group as a whole are best served. It is quite understood that if buying division is buying its input from market rather than in house supplier, it is giving away a profit component to outside party which in ideal course should have been retained in the organization. Same principles apply when one of the department transfers its product to outside buyer rather than in-house buyer. 2. Transfer pricing greatly helps in the settlement of taxation issues especially in the context of trans-national transfer. 3. Keeping a balance transfer price keeps the management of supplying division as well as to the buying division in good stead. 4. Transfer pricing also ensures that the price so fixed is acceptable to tax and government authorities, thus protecting the company from future litigations. Hence the purpose of transfer pricing is to safe guard the interest of organization as a whole by fixing a transaction price between the warring divisions , thus fulfilling the due ambitions of the both the divisions.

Transfer pricing Transfer pricing is the amount charged by one business unit of a company to another business unit for the products supplied. Each business unit is considered as separate responsibility centers and sale from one business unit to another business unit is consider as sale to an outsider. The sales based on transfer pricing are recorded in the accounting books of a firm and transfer prices are used for decision making, merchandise costing and performance assessment. Transfer pricing in centralized firms Transfer pricing does not exist in centralized firms because transfer of products from one business unit to another business unit is not considered as sales. There are no sales recorded when products get transferred from one unit to another for use or further production. Business units in centralized firms are not responsibility centers as they have only costs, not revenue. Transfer pricing exist in decentralized environment where each business unit is considered as responsibility center and responsible for their profitability. Business units are free to decide the transfer price of their products for sale to another business unit or an outsider. Hence, transfer pricing does not exist in centralized environment.

Many firms prefer to have market price, which is a prevailing market price in the intermediate market between independent buyer and seller as the transferring price between the transferring divisions. Say for example if output of division A is input for division B. Then market price of the output of division A, becomes input price for division B. And division A would like to calculate its profit taking this market price into account. And since the remuneration of managers are normally based on the profit that their divisions make. No manager, in such a scenario would like to compromises with his/her remuneration. And always prefer to sell or buy goods at optimal prices which ensure good returns for their division. Now, these are competing interests because selling division would prefer to have maximum price that it can fetch, and buying division would love to buy the standard required quality goods at the lowest prices possible. The equilibrium amongst the competing divisions reaches when they transact at the market price. Why so Say if the selling division prices its output more than the prevalent market prices, then the buying division will have the option to buy its input requirement from the market and not from the selling division. So for the selling division, the market price is the maximum price that it can fetch. On the other hand, if the buying division put a price which is lower than the market price, then the selling division would prefer its product to be sold into the open market rather than to its own buying division. The nature of competing interest amongst the divisions sometime may lead to hampering of organizational interest as a whole. Therefore modern day organizations prefer to have market price as a transaction price between the competing divisions. Because this is the point where equilibrium is reached and organization doesn't loss anything on account of competing interests of divisions. However, there are certain ifs and buts attached to this management decision. The market price can be adopted when there is intermediate market available and goods being traded are standard goods. However, when there is no intermediate market available or products being traded are not of standard, the way out are variable costs of producing those goods.

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question

There is no answer for this question