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Thank You for the invitation :) Coming to the answer, I'll try to put through my understanding of Transfer Pricing as briefly as possible.
Transfer Price is the price which one unit/segment/department/division/etc. of a firm charges for a product supplied or service rendered to another unit/segment/department/division/etc. of the same firm.
Transfer Price can be based on the cost or the market price or it can be bargained or negotiated between the divisions involved.
If it is cost based then it can be the variable manufacturing cost, full manufacturing cost, standard cost, a mark up over the cost can be also charged.
If the basis is the market price then we'll have to depend on the market price being quoted by outside suppliers for the same intermediate good or a substitute, if any. The division can agree to a discount over the market price in order to facilitate inter division transfer thus acting as a means of controlling the overall cost of manufacturing the final product.
The bargained or negotiated transfer price is reached when an acceptable mark up over cost, or a discount over the market price of the intermediate product is reached through a negotiation between the managers of the divisions involved.
The firm can have an over arching transfer pricing policy in place as well, where it pre-determines the transfer price for the various intermediate products in order to facilitate self sufficiency and cost optimisation. But this over looks the benefits of competitiveness amongst the divisions that comes with the freedom of allowance of determination of transfer price by the respective managers of the divisions itself.
Transfer pricing is the setting of the price for goods and services sold between controlled (or related) legal entities within an enterprise. For example, if a subsidiary company sells goods to a parent company, the cost of those goods is the transfer price. Legal entities considered under the control of a single corporation include branches and companies that are wholly or majority owned ultimately by the parent corporation. Certain jurisdictions consider entities to be under common control if they share family members on their boards of directors. It can be used as a profit allocation method to attribute a multinational corporation's net profit (or loss) before tax to countries where it does business. Transfer pricing results in the setting of prices among divisions within an enterprise.
Just like ADMA & NDC with ADNOC in Abu Dhabi, UAE.
Transfer pricing is a mechanism at which products and services are transferred/sold from one department to another within the same company/group, at a certain pre determined price -[variable cost], to support divisional efficiency, and optimization of group profits.
Following are some of the methods used in transfer pricing;
- Actual cost;
- Market value;
- Cost + Profit;
- Negotiated transfer pricing;
Multinational companies passing their tax burdens to their cross border subsidiaries to evade taxes, under transfer pricing mechanism, which is generally regarded as unethical.
A text:
In all but the simplest companies, it often happens that one unit of the firm provides a good or service to another unit, which uses it in a product it sells to the outside world. In some cases, unit #1 has no customer other than unit #2; likewise, unite #2 may have no other source than the internal one, unit #1.
For management control purposes–figuring out whether the units are earning money or doing a good job in other ways, as well as for other reasons I’ll write about below, companies want to decide a notional price at which unit #1 “sells” its output to unit #1. That selling price is called the transfer price. The process of figuring out what the price is is transfer pricing.
Three ways companies use transfer pricing–
Management control:
There are lots of ways of figuring out the transfer price, all with their plusses and minuses.
The process can be complicated. Unit #1, for example, may have external customers as well as internal ones. Unit #2 may have external sources of supply in addition to the internal one. However, internal and external customers may have somewhat different requirements, so products available on the open market may not be strictly comparable to the internally produced ones. So market price may be hard to use. The competitive situation within an industry may also argue against selling to or buying from certain external parties. In addition, cost-plus, another common method, may just institutionalize inefficiency.
The process can also be intensely office-political. This stands to reason, since a dollar of notional profit that goes into the bonus pool of unit #1 is a dollar that stays out of the bonus pool of unit #2, and vice versa. In well-managed companies, everyone is slightly unhappy and things work out for the best. In poorly-run firms, internal pricing may reflect the delusions of the chairman or testifies to the infighting skills of the most “profitable” units–an creates horrible distortions that end in ruin.
Tax planning:
Except for the smallest and simplest companies, there’s no reason that different units in the firm have to be in the same tax jurisdiction. In fact, there may be very good reasons to have them located in different states or different countries.
When I began investing in the Japanese stock market, I soon came across lists of the financial results of foreign brokers located in Tokyo. Virtually every one was making huge losses. As I asked around to try to figure out why this should be, I found out that many trading transactions were legally structured to occur in Hong Kong instead of Japan. Why? The total tax on profits for a transaction done in Tokyo would be over50%. In Hong Kong, the tax would be zero. So Tokyo had the costs of maintaining research, sales, a trading desk and investment banking–and the trades were farmed out to Hong Kong.
At one time, many computer manufacturing operations were set up in Ireland, which offered tax incentives, had a low income tax rate and was inside the EU. Let’s say you make a PC in Ireland and ship it to the UK (a high tax-rate regime) for sale to a consumer electronics store. Should you set the transfer price from manufacturing subsidiary to distribution subsidiary high or low? Obviously, high–unless you had tax loss carryforwards in the UK that you wanted to use up.
You can see the effects of this sort of activity in the low tax rate reported by publicly traded companies with extensive foreign operations.
Twenty years or more ago, investors didn’t like low tax rates. Theorizing that the phenomenon was only temporary, the custom in the UK was for analysts in their reports to explicitly correct or “normalize” the tax rate to whatever the (higher) norm was for a purely domestic company. In the US, investors mostly made a mental adjustment and paid a correspondingly low p/e for the stocks of low tax-rate companies.
Today as far as I can see, no one makes this distinction.
There is one hitch to the low tax rate strategy. For the US, and also typically elsewhere, if the profits held in a low tax-rate regime are repatriated to the home country, they are subject to tax at the full home-country corporate rate. And unless repatriated, the funds can’t be used to pay dividends.
Foreign exchange controls:
Some countries, developing nations in particular, may regard their holdings of hard foreign currency as a scarce national resource. So they restrict companies’ ability to convert local currency profits into foreign currency and send them out of the country.
The most straightforward of the ways creative companies try to get around such policies is through transfer pricing. A foreign company with a subsidiary in a developing economy will typically act as the sole agent for purchases of foreign materials and equipment for its sub, as well as being the distributor of its finished goods abroad. The parent can aggressively mark up the foreign currency price of the materials supplied to the domestic company. And the local sub will sell finished goods at very low prices to the parent, so that the lion’s share of profits will be realized in hard currency and outside the developing nation.
Transfer price is Pricing of goods delivered or services rendered to each other by related companies in order to minimize the overall tax burden for the concern.
Thanks for invitation mir mujtaba and alex , KHURAM IQBAL
very comprehensive
thanx for invitation miss lesley
agreed with the gentlemen
The price at which goods or services are exchanged between divisions/centers etc within the same entity.This can be based on market price or cost.
1)Market rate transfer price-Company sells its goods & services at prevailing market price.
2)Adjusted market rate transfer price.-Make an adjustment to market price based on general concepts and sells in reduced price.
3)Negotiated transfer price-negotiating the price between two parties based on the market price ,transfer price is decided.
4)Contribution margin transfer price.-Price is decided based on contribution margin.
5)Cost Plus transfer price-In the absences of the market price or due to any other reason transfer price is established based on COST+PROFIT.
5) Cost based transfer price-The price is based on cost .
transfer price : is the price of exchange product and raw materials between departments and centers within the same company
types of transfer prices
i) Market-based transfer prices(ii) Full-cost based transfer prices(iii) Negotiated transfer prices
Price charged by individual entities for goods or services supplied to one another in multi-department, multi-office, or multinational firms. Transfer price policy is generally aimed at
(1) evaluating financial performance of different business units (profit centers) of a conglomerate, and/or to
(2) shift earnings from a high tax jurisdiction to a low-tax one.
AGREE WITH MR SAYD RAZA ANSWER