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Management Accounting
Notes to trade with other divisions based on the transfer prices which are quoted. This should
help in supporting the policy of divisionalisation of the business.
4. Allocation of Profit: Transfer pricing can be used to allocate the profits of a multinational
business to division operating in particular countries. The allocation process may be
designed to minimise the liability of the business as a whole or to minimise taxation and
duties. In addition, it is sometimes also used to avoid restrictions on the transfer of profit
within a division that is situated in a country where taxes and duties are low and to report
low levels of profit within a division where taxation and duties are high. This policy will
enable the business, as a whole, to reduce its total liability to taxation (it should be noted
that some taxation authorities will object to this practice if they believe this is simply a tax
avoidance measure).
10.5.2 Transfer Pricing Methods
There are three general methods for determining transfer prices:
1. Market-based Transfer Prices: One of the most rational and practical basis of determining
transfer price is the market price. A company may choose to use the price of a similar
product or service publicity listed in, say a trade journal. Also, a company may select for its
internal price the external price that a division charges to outside customers.
Under certain circumstances deviation from market oriented transfer price may be justified.
Some instances are:
z Where the products involved are highly specialised and a ready market does not
exist, market-price determination will be more difficult.
z Where it is necessary to take advantage of economies of scale in the production of
some goods or services.
z When it is necessary to shift resources from low priority to high priority divisions.
z Where considerations of taxation are applicable.
2. Cost-based Transfer Prices: The basis for transfer price can even be any price that is cost
based. Examples of cost-based transfer prices include variable manufacturing costs, full
manufacturing (absorption) costs, and full product costs. Full product costs include all
production costs as well as costs from other business functions (R&D, design, marketing,
distribution and customer service). This method of transfer pricing is normally used when
a perfect market does not exist for the product. The division cost in this could be actual
cost, standard cost, budgeted cost or marginal cost. The company has to decide which type
of the above stated cost is to be taken into account for transfer pricing.
3. Negotiated Transfer Prices: In some cases, the divisions of a company are free to negotiate
the transfer price between themselves. In the process of negotiation, divisions may use
information about costs and market prices. However, there is no requirement that the
chosen transfer price to have any specific relationship to either cost or market price
data. Negotiated transfer prices are often employed when market prices are volatile. The
negotiated transfer price is the outcome of a bargaining process between the selling and
the buying divisions. This price normally is based on manufacturing costs plus an extra
percentage added to approximate it to market price.
4. Variable-Cost Pricing
z When market prices cannot be used, versions of "cost-plus-a-profit" are often used
as a fair substitute.
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