Transfer Pricing

1. Introduction

2. Determination of Transfer Prices

3. Functions of Transfer Pricing

4. Conclusion

1. Introduction

“Where one unit within an organization supplies another unit with goods or services the payment or receipt made in relation to that supply is a transfer price.”[1] This introducing quote demonstrates the general perception of a transfer price.

According to its definition, transfer pricing is used for a firm’s internal supply and performance. It is always needed when these two terms have to be evaluated. This is often the case if products, assets, services, rights or patents are exchanged transnational between companies.[2]

When analysing exports and imports of large companies it can be seen that a huge amount of this is done among subunits of the same company.[3] These products or services are known as intermediate product. According to estimations, approx. 50% of US imports and more than 30% of US exports are symbolising transfers of supply and performances between organizations. As the previous statement was illustrating, it is very likely that without restrictions on imports and local content regulations there would have been even more exchange activities within organizations.[4]

When regarding transfer pricing, in general, there can be four aspects identified which are requirements for this policy:

            1) Goal congruence should be supported by transfer pricing

            2) Motivation for an efficient use of goods and a reduction of costs

            3) Performance of single subunits should be made appraisable

            4) Subunit managers can decide whether to transact with other subunits or       external parties[5]


2. Determination of Transfer Prices

There are several possibilities to determine a transfer price in practice. These can be classified into three methods:

            1) Market-based transfer price

            2) Cost-based transfer price

            3) Hybrid transfer price[6]

 

For market-based transfer prices the market price of a certain product or service will be chosen as the final transfer price. This method can also be divided into two subcategories which are the pure market price and the modified market price.[7]

The pure market price is defined as the price that has to be paid on the market for a certain product or service. This method can only be applied if there is a probability to substitute internal goods through external goods. Even if a good or service can be substituted by another one, there might still be a problem concerning the amount stated of this product. Due to the fact that potential substitutes have several different values, a company needs to define a price corridor.[3]

When making use of the modified market price, a good’s market price has to be reduced by the costs which would not have emerged in an internal exchange among subunits. In order to reach the transfer price the costs of both sales and procurement have to be deducted. Most of times the procurement and sales costs are not directly determinable. To evade this problem, an international operating organization should identify external and internal transfers to make cost differences visible. However, the question still remains whether cost elements of modified market prices should be calculated with alternative or absorbed costs.[4]

The next method is the cost-based transfer price. The basis of this approach to determine a transfer price are the costs. In practice there are also three different forms for the determination of a transfer price. The first alternative uses the average absorption costing whereas the second one displays the price for alternative costs. The third and last form adds a profit to the preceding ones and is also known as cost-plus-transfer-price.[5]

The hybrid-based transfer price is the price which was agreed by both receiving and releasing unit. The price may orient to objects like market or cost price but does not necessarily need to be bound to them as it could have been chosen as negotiated price.

The actual problem is that the stronger party mostly can enforce their interests and therefore eventually sets the price at their own advantage. This is often the case at parent and affiliate companies where the latter cannot manage to push their interests through.[6]

 

Due to their simple utilization, the first two methods are more applicable in practice. In contrast, the third method is less favoured than the others as it features adverse legal requirements.[7] The listed table below underlines the differences of all three transfer pricing methods.

 

Figure 1: Comparison of Transfer-Pricing Methods[8]


Quellenverzeichnis

[1] Smullen, J.: Transfer Pricing for financial institutions , Woodhead Publishing Ltd, Cambridge, 2001, p. 3.

[2] cf. Kutschker, M./ Schmid, S.: Internationales Management, 6th Edition, Oldenbourg Wissenschaftsverlag, München, 2008, p. 1050

[3] cf. Horngren, C. T./ Datar, S. M./ Foster, G.: Cost Accounting – A Managerial Emphasis, 14th Edition, Upper Saddle River, New Jersey, 2012, p. 802

[4] cf. Kutschker, M./ Schmid, S.: Internationales Management, 6th Edition, Oldenbourg Wissenschaftsverlag, München, 2008, p. 1050

[5] cf. Horngren, C. T./ Datar, S. M./ Foster, G.: Cost Accounting – A Managerial Emphasis, 14th Edition, Upper Saddle River, New Jersey, 2012, p. 802