Transfer Pricing

If molten glass produced using spare capacity is transferred to the Glass Bottles Division at any transfer price in excess of €65 per ton, then the Molten Glass Division's profits will increase by: [(Transfer price - €65) * Number of tons transferred]. Furthermore, if the Glass Bottles Division pays a transfer price of less than €105 per ton (i.e., the price currently charged by the external supplier), then the Glass Bottles Division's profits will increase by: [(€105 - Transfer price) * Number of tons transferred].

Therefore, so far as units which can be produced using spare capacity are concerned, a transfer price which is greater than €65 but less than €105 will result in increased profits for both divisions (compared with the profits which they would earn if they did not trade with each other). In line with the principle of divisional autonomy, it is appropriate to leave it to the two division managers to negotiate the precise transfer price within this range.

Goal congruence is also achieved. By using spare capacity, the company is producing molten glass at an incremental cost of €65 per ton instead of buying it from an external supplier at €105 per ton. Therefore, Cristal Ltd.'s profits are increased by: [(€105 - €65 = €40) * Number of tons produced using spare capacity].

Scenario 3: LIMITED Spare capacity in the Molten Glass Division

This is a variation on Scenario 2. Suppose, for example, that the maximum production capacity of the Molten Glass Division is 45,000 tons per annum. Since there is demand from external customers for 40,000 tons, this means that spare capacity is just 5,000 tons.

Remember that the Glass Bottles Division needs 10,000 tons per annum. Therefore, only half of its needs (5,000 tons) can be produced using spare capacity, and these transferred tons should be priced in accordance with Scenario 2.

If the Molten Glass Division were to also supply the Glass Bottles Division with the other half of its needs (i.e., another 5,000 tons) then it would have to reduce sales to external customers by a corresponding amount. Therefore these units should be priced in accordance with Scenario 1.

Hence in this situation it is optimal to have two transfer prices, i.e., a lower one for transfers which can be produced using spare capacity and a higher one for transfers which involve an opportunity cost because they involve foregoing sales to external customers.

It is important to resist the temptation in these circumstances to use an `average' price for all transfers, because it is sure to be suboptimal. Suppose, for example, that the following situation had been arrived at:

1. For units to be produced using spare capacity (Scenario 2), the divisions agreed on the `midpoint' of the range of acceptable prices, i.e., (€65 + €105) / 2 = €85.

2. As regards units which could not be produced using spare capacity, but would instead reduce the number of units available for sale to external customers, the division managers accepted (in accordance with the logic of Scenario 1) that the transfer price should be €120 (the price charged to external customers whom these transfers would displace).

So far, so good. The transfer pricing arrangement (involving the first 5,000 transfers being priced at €85 per ton, and any subsequent transfers at €120 per ton) is optimal for Cristal Ltd., in line with the logic of Scenarios 1 and 2. But suppose now that we decided to `average' these two prices, to come up with a single transfer price which would apply to all transfers:

- Transfer price = (€85 + €120) / 2 = €102.50.

- It is easy to see that this transfer price is suboptimal. The Glass Bottles Division will want to buy all 10,000 tons of glass from the Molten Glass Division, since €102.50 is lower than the price (€105) which it is paying to its external supplier. But this is not optimal for Cristal Ltd. since (as we saw in Scenario 1) optimization is achieved only if transfers which displace sales to external customers are priced at the price charged to external customers.

Scenario 4: When negotiation fails

We saw in Scenario 2 that inter-divisional negotiations are likely to be needed in order to determine the transfer price which should apply to output produced using spare capacity. But this raises the question as to what should happen if the negotiations fail.

We have seen that the range of transfer prices which should be acceptable to both managers (for output produced using spare capacity) is €65 to €105. But suppose that each division tries to hold out for a transfer price very favourable to itself (e.g., the Molten Glass Division refuses to go below a transfer price of €100 and the Glass Bottles Division refuses to go above €70). Because there is no agreement on transfer price there will be no inter-divisional transfers, and the Glass Bottles Division will continue to buy all of its molten glass from the external supplier at €105 per ton. Since the company could have produced this molten glass for €65 per ton, this is clearly suboptimal for Cristal Ltd. as a whole.

When division managers cannot agree on a transfer price, should the company's top management intervene to order the divisions to make the transfer if (as in this case) it is obvious that the transfer would be in the company's best interests? The answer is no. There are two reasons for this:

1. For the reasons stated earlier, the preservation of divisional autonomy is an important principle which should not lightly be breached.

2. If the division managers are allowed to suffer the consequences of their own intransigence, then they are unlikely to make the same mistake in future. For example both managers will be aware that if they had `split the difference' and agreed on a transfer price of €85 per ton, then they could each have earned an incremental profit of €20 per ton. By failing to agree a price, they have deprived themselves of this profit in the current period. They are likely to remember this lesson in future transfer pricing negotiations. [16, 17]

2.2 Further coverage of transfer pricing methods

For example, Drury discusses five main methods of transfer pricing in considerable detail. However if students understand the basic principle of transfer pricing set out at the beginning of the previous section (i.e., that transfer price should be equal to the marginal cost of producing the transferred product or service plus the opportunity cost of making the transfer) and the four scenarios outlined above, then they already have a basic knowledge of the logic which underlies three of Drury's five methods (market-based transfer prices, marginal cost transfer prices, and negotiated transfer prices). [18]

Drury's other two methods are full cost transfer prices and cost-plus-markup transfer prices. The mechanics of these methods are easily illustrated. Returning to the basic data given above in relation to the Molten Glass Division, the full cost per ton can be calculated as follows [16]:

The full cost method involves using €83 as the transfer price per ton. The cost-plus-markup method involves using this full cost plus some profit markup. These methods often (but not always) cause suboptimisation. For example, if we consider Scenario 1 in the previous section, it is clear that the full cost transfer price (€83 per ton) would be too low where no spare capacity exists. However, in Scenario 2 (where spare capacity exists) it is clear that the full cost transfer price of €83 per ton would lead to optimal decision-making in these circumstances (and, in fact, would split the incremental profit reasonably equitably between the two divisions).

Other issues in transfer pricing:

There are a couple of other issues which commonly arise in exam questions on transfer pricing:

1. Selling costs: Often there are selling costs which arise if goods are sold to an external customer but which are avoided if goods are transferred to another division within the company.

This should be allowed for in determining the opportunity cost of making the transfer. For example in Scenario 1 above, we calculated the opportunity cost of transferring a ton of molten glass to the Glass Bottles Division (instead of selling it to an external customer) as €55 per ton. But suppose now that there is a sales commission of €3 per ton when molten glass is sold to an external customer, but no sales commission if goods are transferred to the Glass Bottles Division. In these circumstances the opportunity cost of making the transfer is reduced to (€55 - €3 = €52). The optimal transfer price is reduced accordingly.

2. Strategic considerations: For strategic reasons a company may require its divisions to trade with each other even where external markets exist. For example a company such as Volkswagen may not wish its engines manufacturing division to sell its engines to rival car manufacturers, and may require that its car manufacturing division uses engines produced within the Volkswagen Group. In other words although external markets for engines exist, the company (for strategic reasons) the company does not wish the divisions to use them. [16]

Transfer pricing mechanisms which rely on external market prices (as in Scenario 1 above) clearly will not work in this situation. One solution is for the selling division (i.e., the engines manufacturing division in this example) to be paid the marginal cost for each engine (which is the optimal transfer price since there is no opportunity cost) plus a lump-sum fixed annual fee (to enable the division to cover its fixed costs and show a profit).

Conclusion

Globalization is basic direction development of all spheres of life, including industrial. Open border, free exchange a commodity, an intellect, technologies and information, is by pre-condition of origin of high standards and strong market competition. It forces modern enterprises and organizations of the whole world to answer these criteria. Terms, functioning of modern economy, that characterized by a keen competition, require from guidance the companies of permanent modernisation of business processes of enterprise, use of innovative technologies.

So effective transfer pricing is one of the reasons of multinational corporations` effective competition on the market.

Transfer pricing is the set of mechanisms which is used to attach prices to goods or services which are traded between two divisions of the same company. The classic example involves one division (the “selling division”, or “SD”) which produces a component which is required by another division (the “buying division”, or “BD”). The component is used by the BD in the manufacture of a product which it sells on the open market.

In this work it was noticed that every big company has effective serious transfer pricing policy, different scenarios, methods and principles. It was clearly shown with the help of Crystal Ltd company example.

References

1. Pitelis, Christos; Roger Sugden (2000). The nature of the transnational firm.

2. Doob, Christopher M. (2013). Social Inequality and Social Stratification in US Society. Upper Saddle River, NJ: Pearson Education Inc.

3. Jump up Gio Wiederhold (2013): Valuing Intellectual Capital, Multinationals and Taxhavens; Springer Verlag, August 2013.

4. Jump up Michel Aujean (chair) (2001): Company Taxation in the Internal Market; Commission of the EC, 23 Oct 2001

5. Jump up Ronen Palan (2010): The Offshore World: Souvereign markets, Virtual Places, and Nomad Millionaires; Cornell University Press, 2006.

6. Jump up Several websites provide overviews of transfer pricing regulations by country, such as the Country References on the TPanalytics website.

7 Jump up Note, however, that customs, anti-dumping and import restrictions may in effect impose advance restrictions on prices charged.

8. Jump up TD 8552, 1994-2 C.B. 93.

9. Jump up For history of the OECD efforts, see paper presented to the United Nations in 2001.

10. Jump up See OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, hereafter OECD xx, where xx is the cited paragraph number.

11. Jump up See 26 CFR 1.482-0 et seq.

12. Global Transfer Pricing Solutions: Fifth Edition

13. Jump up See, e.g., OECD 1.1 et seq., 26 CFR 1.482-1(b).

14. Jump up OECD 1.45, 41; 26 CFR 1.482-1(e).

15. Jump up OECD 1.15, 26 CFR 1.482-1(d)(2).

16. Drury report

17. https://www.kpmg.com

18. http://www.crystalltherm.com/

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