The amount charged by a subsidiary department to another subsidiary department for transfer of products is known as transfer price. This process of charging the transfer price is termed as transfer pricing method. This method is useful to save income tax mainly for big MNC’s. Apart from this, the organizations can increase their efficiency levels as this process involves different departments (Lohse, Riedel and Spengel 2012).
Melnyk et al. (2014) opine that there are more than a few types of transfer prices can be explained with the help of the following diagram:-
Cost base transfer price are those when the particular department charges processing fee by adding it to manufacturing cost to get a profit margin. Cost-based transfer pricing can be further classified into three different types, which are variable cost, actual full cost and standard costs. Companies generally use cost-based transfer pricing when there are no external market prices available to the companies (Drury 2013).
Companies based on the current market price prevailing in the market use market-based transfer pricing. This method is widely used by modern business organizations. However, the major problem of this method is that it is extremely difficult to establish an effective market price (Melnyk et al. 2014)
In case of cost-plus transfer pricing method, the total amount of intangibles is measured and the transferred parties calculate sum of gross profit. This method is useful in case of semi-finished goods (Otley and Emmanuel 2013).In addition to this, this method is used when the manufacturing units sell their respective goods to the distributing unit of the firm. The implementation of this method is very simple and its useful for several entities.
Companies use this type of transfer pricing by adjusting the market rate taking into consideration several other factors and policies that varies from one company to the other.
In many cases, transfer prices are negotiated from one department to the other one. Such process of transfer pricing is known as negotiated transfer pricing.
There are various reasons behind the usage of the above types of transfer pricing process.
Cost plus transfer pricing method is used in case of semi-finished goods. In this method, costs can be classified into three major categories, which are direct costs, indirect costs operating costs. In this method, total profit is allocated in various departments (Warren, Reeve and Duchac 2013).Apart from this. Different taxpayers may implement this method in case of pricing of the required goods when the goods are transferred from manufacturing to distribution units.
Cost-based method is useful in determination of exact amount of cost of the final product. On the other hand, market-based transfer pricing method is used in case of allocation of all the units at the prevailing market price and the total cost of production is calculated based on the market price only. It can be also inferred that market rate includes several other factors like systematic risks, bad debts, etc. However, not all these expenses may be applicable in the process of transferring units from one department to the other one. Due to this reason, different companies use adjusted market pricing method in order to eliminate such expenses (Lohse, Riedel and Spengel 2012). Apart from this, the negotiated transfer pricing method is also useful in preserving the autonomy of different divisions. The managers of the company have clear and specific ideas about the benefits and potential cost of the company. They are in much better position to analyze the situation and offer necessary information. In this type of transfer, the managers of the organization meet to discuss about the conditions of the transfer. However, a loss is about to occur in the transaction if the transfer price is lower than the cost of selling division. Market based transfer pricing is one of the best means that is used in case of pricing method. In case of maintain the supply chain of a smaller company there are different divisions. On the contrary, in case of the larger companies there are too many inter linked divisions where the pricing method could not be used once. In such cases, the companies use transfer pricing. This helps in understanding the price between divisions of the concern. Normal market rate is use like open market. This is one of the easiest pricing methods that are used to determine the price within the same organization (Kaplan and Atkinson 2015)
There are various purposes behind the usage of transfer prices. It has been often seen that an organization can have different processing units that come under different tax jurisdiction. The transfer pricing method will assist the particular organization the taxes in an accurate manner (Horngren et al. 2013). It has been also seen that one department of the company may incur higher tax rates. In that case, if the profits are distributed equally in various departments, then, the tax payable amount can come down. Apart from this, transfer prices also help the management of the organization to decisions in case of selling of products or transferring different units to the other departments. This method is also useful to measure the efficiency of the different departments of the organization.