Transfer Pricing

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7 Transfer Pricing

LEARNING OBJECTIVES :
After studying this chapter students will understand.
* Purpose of transfer pricing
* Responsibility of a division as responsibility centre * Conflicts between the divisions
* Setting of transfer price where the profit of the organisation can be higher. 7.1 Introduction
The whole organisation can be divided into a number of divisions, the performance of each division can be measured in terms of both the income earned and the costs which are incurred. In profit centred divisional approach the manager of each division is responsible for cost, income and profit of his division. Further he is given freedom to make all decisions affecting his division. In such a decentralised organisation there may be transfer of goods from one division to another division. The price charged for transfer of goods of one division to another division is the cost to receiving division and income of supplying division. It means that the transfer price fix will affect the profitability of both divisions. 7.1.2. Definition : Transfer price can be defined as the price charged for products exchanged in internal transactions between sellers (or transferors) and buyers (or transferees) who belong to the same organisation usually a decentralised organisation. 7.2 Objectives of Transfer Pricing System

The main-objectives of intra-company transfer pricing are as below: * i)  This motivates manager of a division to maximize profit of the division and inturn the profit of the company as a whole. * ii)  To utilise capacity of the plant and other resources as maximum as possible. * iii)  To optimise allocation of financial resources. 7.3 Methods of Transfer Pricing

The methods of pricing usually employed in industry when goods or services are transferred from one unit to the other can be broadly classified under the following three categories: i) At cost or variants of cost e.g. actual manufacturing cost; standard cost; full cost and © The Institute of Chartered Accountants of India

7.2
Advanced Management Accounting

full cost plus mark up. At market price.
ii)
iii)
A brief discussion of these methods is given below. 7.3.1 Pricing at Cost * (a)  Actual manufacturing cost: 
In this method goods or services are transferred at their actual cost of production. It is useful for those units where the responsibility of profit performance is centralised. Under this method, it is difficult to measure the performance of each profit centre. * (b)  Standard cost: 
Under this method all transfers of goods and services are made at their standard cost. Any difference between actual and standard cost viz., variances are usually absorbed by the supplying unit. In some cases, variances are transferred to the user unit as well. This will result in the inventory being carried at identical standard cost by both the supplying and receiving units. Here also the profit performance responsibility is centralised and thus it cannot be measured for individual units involved. * (c)  Full cost: 
Full cost means cost of production plus expenses like selling and distribution, administration, research and development cost etc. In this method, the supplying unit is not allowed to make any profit on transfers to other units. But it is free to earn profit on outside sale. One good thing about this method is that the supplying unit is allowed to recover the full cost of the goods/services transferred. * (d)  Full cost plus mark up: 
Under this method the supplying unit transfers goods and services at full cost plus some mark-up. The mark-up added to full cost is either expressed as a percentage of full cost or of capital employed. Selling expenses here are recovered by the supplying unit without incurring them, especially when the goods/services are transferred internally. Due to this defect the use of full cost plus method is not appreciated by the internal receiving units. To...
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