Transfer pricing is a subject that crops up on the CIMA P2 paper and here is my take on the subject.
What is Transfer Pricing?
Transfer pricing is common place among multi national corporations where there are high volumes of “inter-company” activity. Companies tend to use transfer pricing to lower their overall tax bill of the group.
Rather than get bogged down with lengthy theory and explainations, I feel the best way to explain is to illustrate with simple examples.
Company NOT using Transfer Pricing
- Here you can see a traditional relationship between different departments within a business.
- Division A makes purchases of raw materials for 80 and after production in A they add labour costs of 20.
- Division B finalises the product and incurs costs of 40 and sell the product to the end customer for 200.
- You can see straight away while the Group as a whole has made a profit of 60 from this production, the manager of Division A will be reporting a loss of 100, while his counterpart in Division will be reporting a mega profit of 160.
Company USING Transfer Pricing
- In this instance, the company has an internal agreement to charge a transfer price between divisions.
- Division A has charged 150 to Division B, while the selling price to the end customer remains the same at 200.
- You can see the transfer pricing DOES NOT IMPACT the total profit made by the group when consolidated, but it allows each division within the company to be measured efficiently and effectively
- Therefore, increasing the motivation of the individual division managers to be more cost effective and improve efficiency within the department, which, in turn, improves the profitability of the division and group as a whole.
In the first example, where transfer pricing is not employed the management of division A have no incentive of meaningful performance measurement as they will always considered to be loss making.
Transfer Pricing and Tax Implications
One of the main reasons why large multi national companies use transfer pricing is to accrue profits in countries that have a lower tax rate.
Using the figures from the above example I have illustrated the tax implications if Division A is based in a country with a tax rate of 5% while Division B is based in a country with a tax rate of 20%
- It’s obvious that the company who has implemented transfer pricing will be paying a much lower tax bill due to the fact most of it’s profits are made in Division A where there is a much lower tax rate.
- However, transfer pricing must be set within the scope of the law and it can become a complex matter.
The above examples are very simple in terms of the numbers and structure of the business but the underlying principle of transfer pricing remains the same.
Methods of Transfer Pricing
So now we have established what transfer pricing is and the benefits to be made by accruing profits in countries with lower tax rates (within the scope of the law). Let’s take a look at the different methods on how the Transfer Price itself can be calculated.
Cost Plus Price Model
One of the most simplest and common approaches (especially with high volume producing businesses) to be employed is the cost plus price model. This is where the group agrees that the selling business unit will add a fixed percentage to their costs as a base for the transfer price.
- The agreement is for Division A to adopt a fixed cost plus price model of 20% for their transfer price to Division B.
- Which is fine at the current levels of costs, as both divisions and the group overall are making profits.
- However, the manager of Division A has realised he can increase the profits of his division by increasing costs – BUT TO THE DETRIMENT OF THE GROUP AS A WHOLE!
- Here we can clearly see the dysfunctional behaviour that can be encouraged by using a cost plus price transfer pricing system.
- Division A manager is happier as he made double the profit by doubling his costs but Division B has made a big loss on this and lead to an overall loss at group level.
In fact, if any divisions are set to lose money on a deal then they will more than likely refuse to do so, even at the expense of the company. Of course, decisions can be made at a group level which enforces the trade between divisions at any cost but it would be demotivating for the buying manager as they lose autonomy.
Minimum Vs Maximum Transfer Price
A more common sense and goal congruent approach is to ensure that firstly the group can make a profit overall, then deciding on the minimum transfer price that can accepted by the selling division and the maximum transfer price that can be accepted by the buying division and them agree on the price somewhere in the middle of the that range.
In the below example I’ve also thrown in the possibility that Division A can also sell the goods directly to an external party.
- The selling division (A) determines the minimum price of 200 – as they can sell it externally for this price, so the transfer price must at least match this.
- The buying division (B) has costs of 100 and selling price of 350, so the maximum they could pay would be 250 as a transfer price.
- This gives the group a transfer price somewhere between 200 and 250 to be goal congruent and suit all divisions involved.
Finally, you can see the transfer price of 200 has been agreed and both divisions make an equal share of the 100 profit made by the group.