Transfer pricing is essential for financial management in large companies with multiple divisions. It involves setting the price at which one division sells goods or services to another within the same company, confirming fair performance measurement and profitability.
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What is Transfer pricing?
Transfer pricing is the price at which we transfer goods and services from one unit of a company to another. Big companies which are bound have big branches. Those branches sell or purchase goods from each other and the price at which they are selling or purchasing the goods is called transfer price.
For example, there is a company called Amul, one of it branch is Amul Milk and the other branch is Amul Butter. So, the Amul Butter branch requires milk to make butter. This is either be purchased from Amul Butter or from the market. When Amul Butter buys butter from its own branch Amul Milk, and the price at which Amul Milk sells milk, that price is called transfer price.
Transfer price is normally set for intermediate products (which are the products that we need to make into a finished product) where selling division sells intermediate products to the buying division.
For example, in Amul, when Amul Milk supplies milk to Amul Butter, the transfer price is the rate of this transaction. Here are several methods to determine transfer prices:
- Cost Price: Goods are transferred at their actual production cost.
- Cost Plus a Normal Markup: A profit margin is added to the cost price.
- Standard Cost: A predetermined cost is used, which requires regular updates.
- Market Price: Prices are based on current market rates, adjusted for internal savings.
- Shared Profit Relative to Cost: Profits are shared among divisions based on their cost contributions.
- Negotiated Price: Divisions agree on a transfer price through negotiation.
Methods of transfer prices in Detail
1. Cost price
Cost price means the actual price of the goods. In this method, whatever good and services we transfer, we do so at the actual price. This is a very simple method to operate but the profit of the transferring company is underestimated because it is selling at the cost price.
For example, a company is manufacturing a unit at Rs. 8 and it is selling the same unit to another company at the same price of Rs. 8, then it will not have any profit left and the profit of the buying division will increase. The profit of selling division becomes underestimated and profit of purchasing division becomes overestimated.
2. Cost plus a normal markup
In this method, we take the cost and plus we add a margin to it which is called normal mark-up adding some margin of profit on cost like 10% margin, 15% margin to determine transfer price. In this method, the buying division is charged the actual cost-plus margin on it.
For example, if the price of an item is ₹10 then a margin of 10% is charged which comes to price 11= 10 + 1 so selling division will charge ₹11 from the buying division.
3. Standard cost
Standard cost means predetermined cost. In this method, we fix a price in advance based on standard costing. In this method, we estimate in advance how much our cost will be and how much margin we will have to add to it so that we get profit, so we set a standard price well in advance.
For example, suppose our standard costing is ₹10 which we had already estimated and now the cost we are getting is ₹8, so we will get ₹2 profit because the cost is ₹8 and we are selling it for ₹10, so we get a profit of ₹2 but, if standard costing is Rs 10 and cost is coming to Rs 12 then we incur a loss of Rs 2 because we are sealing on standard costing only. Whatever variance there is, whether it is a profit or a loss, the transferring company, which is the selling company, has to observe that variance. It is very simple and easy but standard cost has to be constantly revised at regular intervals.
4. Market price
In this method, we set the price according to the market price. We decide by looking at the prevailing price in the market.
Example Amul is a company, its two branches are Amul Milk and Amul Butter. Now Amul Milk is supplying milk at ₹10 and the market price is also ₹ 10, Amul Butter will say that the market price is also ₹10, why should I buy milk only from Amul Milk, what is my benefit?
Where Amul Milk tell Amul Butter, we will give you milk after deducting the selling and distributing cost because the market price is usually set when the cost price and selling and distributing cost are added. Amul sells milk to Amul butter by deducting selling and distributing cost because Amul butter is directly purchased from Amul milk, there is no advertising cost charged, for example cost is ₹9 and selling and distributing cost is 1 so Amul Milk will deduct selling and distributing cost and supply milk at ₹9 to Amul Butter.
Advantage of Market Price
- Actual cost fluctuates widely and is difficult to ascertain and when it comes to market price it is easily ascertain
- Selling and distributing cost and cost of bad debts is reduced because we are not doing any advertising and purchases are made directly.
Disadvantages
- There may be resistant from the buying division
- Market price can also be fluctuating and has difficult in fixation of prices
- Market price is a vague term because price may be factory price, wholesale price and retail price
5. Shared profit relative to cost
In this method, no price is charged. For example, Amul Milk will not charge any price from Amul Butter rather out of total sale revenue of the company the total cost of various division is deducted to find out the profit of the company and then share the profit among the divisions based on cost, as total cost is deducted from total sale and only profit is left with them, so profit will be shared among the division on the basis of cost.
Formula to calculate profit based on cost
Profit of company Multiply by cost of division divide by total cost
For example, a company’s sales are 2 lakh and its cost is 1 lakh, then its profit will be 1 lakh. If this company has two branches A and B, the cost of one is 60,000 and the cost of the other is 40,000.
So, A’s shared profit will be 1,00,000*60,000/1,00,000= 60,000
B’s shared profit will be 1,00,000*40,000/1,00,000= 40,000
6. Negotiate Price
In this method, the price is fixed by negotiating. Negotiation is based on the selling division and buying division. They sit together and negotiate with each other and set a price. Sometimes some product becomes available in the market at a lower price, the buying division does not consider buying it from the selling division because it does not get any benefit in it. In this case, both the buying division and the selling division negotiate the price and set a price mutually.
For example, if the selling division is selling a unit for Rs 10 and the same unit is being sold in the market for Rs 9, then the buying division will say that there is no profit for me in this, if I buy it from the selling division, then it will think of buying it from the market, so in this, the selling division and buying division negotiate and decide a price.
Frequently Asked Questions of Transfer Pricing
Can transfer pricing impact tax liabilities?
Yes, transfer pricing can significantly impact a company’s tax liabilities. By setting appropriate transfer prices, companies can optimize their tax positions and comply with international tax regulations.
What should companies consider when choosing a transfer pricing method?
Companies should consider factors such as market conditions, cost structures, regulatory requirements, and strategic goals when selecting a transfer pricing method.
Why is transfer pricing important?
Transfer pricing is crucial for accurately measuring the performance and profitability of different divisions within a company. It also helps in tax optimization, compliance with regulatory standards, and minimizing the risk of tax disputes with authorities.
What are the advantages of the market price method?
Reflects actual market conditions.
Reduces selling and distribution costs.
Eliminates the need for advertising costs in internal transactions.
Reduces selling and distribution costs.
Eliminates the need for advertising costs in internal transactions.
What are the disadvantages of the market price method?
Resistance from the buying division.
Fluctuating market prices can complicate price setting.
Ambiguity in determining the exact market price (factory price, wholesale price, or retail price).
Fluctuating market prices can complicate price setting.
Ambiguity in determining the exact market price (factory price, wholesale price, or retail price).
Conclusion of Transfer Pricing
Transfer pricing is an essential financial management means for large companies with multiple divisions. It guarantees that internal transactions are directed fairly and visibly, allowing for accurate performance measurement and profitability analysis. By setting appropriate transfer prices, companies can prevent disputes between divisions, optimize tax liabilities, and comply with regulatory requirements.
The transfer pricing methods — cost price, cost plus normal markup, standard cost, market price, shared profit relative to cost and negotiated price — each offer different benefits and challenges. Selecting the right method depends on a company’s specific circumstances, including market conditions, cost structures and strategic goals. Effective transfer pricing policies can increase a company’s overall efficiency, promote collaboration between departments and contribute to its long-term success.