Transfer Pricing and Corporate Policy
Introduction and operation of an effective system of transfer pricing in an organizations is entangled with at least major characteristics of corporate policy. They are:
Divisional autonomy, Transfer pricing, and Performance evaluation.
The first two characteristics are specific ingredients of common regions of corporate control. Mainly big organizations may be divisionalised. The divisional managers' freedom of action is not complete. Divisional managers are to create periodic reports to the headquarters. The corporate policy on this may contain:
The stage of details in these reports,
The accountability of decisions and actions,
The frequency of in excess of-ruling of the divisional manager's decisions, and so on.
The headquarters closely controls those characteristics which affect the operations of other divisions. This comprises quantities of output transferred in the middle of the divisions as also the price at which the transfer takes lay (the transfer price). Separately from control thoughts the headquarters necessity also is concerned with policy concerning evaluation of performance of the divisions. The evaluation of performance of the division is necessary for the `rewards' and 'punishments' to be decided for the divisional managers. The rewards and punishments of the divisional managers have to be based on some observable objective events such as sales, profits, cost reductions, innovation, improvements, and growth. The corporate policy determination in the context of divisionalised firms involves two decision-creation stages. First the headquarters which sets overall performance evaluation and the corporate control policies and secondly through which set the enterprise stage policies relating to discretionary controls such as physical outputs, prices and the like.
The divisional managers who control enterprise stage variable would like to maximize their benefits. The benefits depend on the evaluation criteria set through the headquarters. The outcomes depend on the corporate control policies and environment factors. The environment factors such as market condition competition price, taxation and so on are exogenous or given for any enterprises. Mainly of this environmental variable may be uncertain and will force the divisional manager to take decisions under uncertainty. It is in this context of setting corporate policies relating to evaluation and control that we have to seem at transfer pricing and its implications for performance evaluation and corporate control.
Criteria for Determining Transfer Pricing
It will be advisable to formulate sure criteria before determining the transfer price. Those criteria may be as follows:
Transfer price should help in accurate measurement of divisional performance.
Transfer price should motivate the divisional managers into maximizing the profitability of their divisions and creation decisions which are in the best interest of the organization as a whole.
The transfer price should ensure that divisional autonomy and power is preserved.
The transfer price should allow goal congruence to take lay. It implies that the objectives of the divisional managers are compatible with the objectives of overall company.
A transfer pricing system should check the international clusters which may attempt to manipulate transfer prices flanked by countries with a view to minimize the overall tax burden.
Methods of Transfer Pricing
In practice, many methods are used for transfer pricing. Though, there are two vital approaches to determination of transfer price. They are:
Market based; and Cost based.
Market Price
The mainly popular method of determining transfer pricing is the market price, as it is quite reasonable for supplying division as well buying division. It is not hard, as the price is easily accessible in the open market. When there is a well-recognized market for the goods or services to be transferred. The transfer price can be easily determined on the market price foundation. Though, such market price should be taken as ceiling limit for transfer price. When divisions have the alternative to buy or sell from the open market, they would transfer to buy or sell from sister division. When transferred goods are recorded at market price, the divisional performances are more likely to symbolize the real economic contribution of the division to total company profits. Under sure circumstances, there may be deviations from market-based transfer price. Some instances, for such deviations, are as follows:
Where the products involved are highly dedicated and a ready market does not exist, market- price determination will be harder.
Where it is necessary to take advantage of economies of the level in the manufacture of some goods or services.
When it is necessary to shift possessions from low priority to high priority divisions. Where thoughts of taxation are applicable.
Market-based transfer pricing is more commonly used, as it offers following advantages: They are one of the mainly easy and easily understood methods.
They minimize the complications for performance evaluation. They reduce points of disagreement flanked by several divisions. They are usually constant with the environment outside.
Cost-based Prices
When external markets do not exist or are not accessible to the company or when correct information in relation to the external market prices is not accessible, the cost based transfer price may be used. The cost-based prices methods may be as follows:
Variable Cost Actual Cost
Cost plus a normal spot-up Average Cost
Opportunity Cost
Variable Cost
Under this method, only variable manufacture cost is taken into explanation. In variable cost, the cost of direct material, direct labour and variable factory overhead are incorporated. In other words, fixed cost is not incorporated in it. Variable cost method for transfer price may be useful when the selling division is operating below capability. Though, the selling division manager would not like it as a foundation for transfer price, as it does not give the profit to that division.
Actual Cost
If transfer prices based on actual cost, it would contain total or full cost of manufacture per element. It is an easy and convenient method, as the required information is accessible in the accounting records. Though, the selling division would not earn any profit on goods or services transferred to the buying division. The buying division would stand to gain, as it would be lower than the market price. Though, it is quite inappropriate for profit center analysis.
Cost Plus Normal Spot-up
Under this method, the transfer price contains cost per element plus some profit margin or normal spot-up. This spot-up price may be determined in two ways. Either the management of the company may set a target profit or it may be equal to the profit Margin that competing firm might reasonable be expected to realize. Though, the decision in relation to the ‗percentage‘ of spot-up may be arbitrary and questionable.
Average Cost
Average Cost is pre-determined cost and is also described `engineered cost'. In practice, it may appear to be more practical and useful and may be taken to be a good choice for transfer price. Average cost based transfer price encourages efficiency in the selling division as inefficiencies are not transferred on to the buying division. Use of average cost reduces the risk to the buyer.
Opportunity Cost
Often in practice, the determination of transfer price on market price or cost may be hard. Under those circumstances, the transfer price may be based on opportunity cost. Such pricing may also be required where the supplier division is a monopoly producer or the user division is a monopoly consumer. The transfer price may be fixed at a stage which equal the opportunity cost of the supplier division and the user division. It also identifies the minimum price that a selling division will be willing to accept and the buying division will be willing to pay. The opportunity costs based on transfer prices for each division are as follows:
Selling Division: For the selling division, the opportunity cost of transferring is the greater of:
o The outside sales value of the transferred product; o Differential manufacture cost for the transferred product.
Buying Division: For the buying division, the opportunity cost of acquiring through transfer is the lesser of:
o The price that would be required to purchase from the outside;
o The profit that would be lost for producing the final product if the transferred element could not be obtained at economic price.
In the economic interest of the company, it would be better if the opportunity cost for the selling division is less than the opportunity cost for the buying division. The practical difficulty may arise when the divisions will tend to overstate or understate their opportunity cost so as to power the transfer price to their advantage. Under such condition, the central management may look at it and bring the necessary changes through obtaining necessary information in this regard. There are two other methods of determining the transfer price. They have been; described briefly as follows:
Negotiated Prices
In practice, the transfer price is determined on the foundation of negotiations flanked by the selling and buying division. It may be flanked by the market prices and the cost-based price. While negotiating the price, the seller division manager and buying division manager act much the similar as the managers of self-governing companies. If the transfer price is based on negotiated price, the company, as a whole, stands to benefit. Such price avoids mistrusts, bad feeling, and undesirable bargaining interest in the middle of divisional managers. It gives an opportunity to achieve the objectives of goal congruence, autonomy, and accurate performance evaluation. The negotiated price foundation may have some limitations also. They are:
In the procedure of negotiation, a great deal of management effort, time and possessions may be consumed.
Such a price may also depend upon the ability and skill of managers concerned.
One divisional manager may take advantage of having some private information which the other manager may not possess. With the result, the negotiated price may not be accurate.
Dual Prices
It is also recognized as `two-way prices'. Under this method the selling division is credited with one price. That may be cost plus profit margin whereas the buying division is charged at dissimilar price, which may be equal to variable cost. The variation in the transfer prices for the two divisions could be accounted for through a centralized explanation. The dual pricing provides motivation and incentive to selling division as goods are transferred at cost plus some profit margin. On the other
hand, for the buying division, it would be quite appropriate price. Often, the use of dual prices may lead to a divergence flanked by the segment profits and those of company. Though, this is not a serious issue and can be resolved in the interest of the divisions concerned.
Decentralization and Performance Evaluation
Every organization aims at attainment of some group-objectives. A significant consideration in organizing behaviors is the congruity flanked by the objectives of the individuals in the group and the group. Where such congruity the group goals would be achieved automatically with the attainment of personal goals. In reality, though is a natural contradiction flanked by individual goals and the group goals. A vital contradiction which can be easily understood is the information that the individual tends to want to put a little part of effort into attainment of the group's goals and at the similar time like to share a superior part of the benefits of the group's behaviors. It is in the context of this natural tendency that the group necessity imposes some performance evaluation of the individual. The share of the individual in group-achieved benefits (or results) should be proportional to some observable contributions of the individual to the group's objectives. The group behaviors are to be left to the individuals and what success criteria are to be measured in the evaluation of the contribution made through the individual towards the group. The action of the group to be left to the individual's decision will determine the degree of individual autonomy. The success criteria to be used for evaluating the individual's contribution to the group will determine the method of performance evaluation.
The set of observable success criteria may be taken to contain absolute profit stages, profit rates, cost stages, revenues, market share, product improvements, augment in productivity and so on. Managers on the other hand base their controls on several variables such as quantities of inputs purchased and consumed, quantities of output produced, prices obtained on outputs, expense incurred on marketing, research and development, product improvements and so on. It is usually agreed that there are three major principles for developing and implementing performance evaluation system:
The criteria and procedure of performance evaluation should be clear and explicit and the superior and subordinate should have general understanding prior to the beginning of the evaluation era.
The criteria of performance evaluation should be as accurate possible. It is ideal to use a multiple criteria of performance than any single criteria.
Transfer Pricing Practices
There is a big amount of documented sources on the transfer pricing policies used through companies all in excess of the world. These studies have documented several characteristics of transfer pricing policies such as:
Its role as an overall component of reporting and control system in companies, The effect of transfer pricing on intra-corporate conflicts,
Variations in transfer pricing policies crossways the world, and Environment constraints on use of transfer prices.
A brief summary of transfer pricing practices is as follows:
Companies tend to seem at transfer pricing not presently as a mere accounting exercise, but also as a significant tool in policy formulation towards attainment of corporate objectives. Transfer pricing acts as a major source of political disagreement within the organization and
this takes lay irrespective of the method used for this purpose. Dissimilar methods may, though, augment or decrease the possibility of disagreement.
Companies tend to use a diversity of transfer pricing methods. Though, the dominant in the middle of them are the market prices or the methods based on modifications of the market prices.
Even though several companies use transfer prices as a policy variable, it is not the major or principal policy variable.
International companies use conscious manipulation of transfer prices as an instrument of maximizing attainment of corporate goals. An explicit instance is the transfer of profits from subsidiaries to parent companies or other companies in the group through transfer pricing policies relation to supply of capital equipment or inputs through multinational companies.