When one department of the company manufactures some product which is supplied to another department of the company, transfer pricing issue arise that at which price transfer from one department to another should be made so performance evaluation of both departments can be made.
Evaluation of Transfer Pricing Policies
The transfer pricing policies are adopted by the company based on the evaluation of risks involved, use of assets and market conditions.
- Cost Plus Method: Cost plus method focuses on the related manufacturing department as the tested party in transfer pricing analysis. It begins with the cost incurred by the department and markup is then added to this cost to make an appropriate profit because of functions performed, the risk assumed and assets used. It is calculated by the help of following formula:
Transfer Price = Cost + Markup for Selling Division
The cost-plus method is used to analyse transfer price issues that involve tangible property or service. It is most useful when it is applied to manufacturing or assembling activities. This method evaluates the arm length nature of inter-department charges regarding the gross profit markup on costs incurred by the supplier department.
This method compares the gross profit markup earned by the department manufacturing the product to the gross profit markup point by other comparable departments. If we assume the cost of manufacturing of department per unit comes $5,000, and we assume gross profit markup of the department in the associate enterprise should earn is 50%, then the resulting transfer price will be $5,000 + 50% of 5,000 = $7,500.
Fair Market Value Method
If the product is salable as manufactured by the department without further processing, then this method can be applied. Under the fair market value method, the transfer price from one department to another is the market price of the product which the transferor department is manufacturing.
This method presumes that the transferor department has manufactured the goods and earned the profit for the company with the assumption that the goods are sold in the market and the transferee department if purchases the article from the market what will be the cost of transferee department. This method justifies the performance of the transferor department as well as the transferee departments.
Price Negotiated by the Managers
Sometimes neither cost plus markup price nor market price is transferred price of the product, but it is mutually decided by the managers of the transferor and transferee department. The managers consider the cost of the transferor department and also the reasonable profits that should be assigned to the transferor department for its efforts and utilisation of assets and risks borne by the department in the manufacturing of the product.
At the same time, the concerning cost to the transferee department is also taken into consideration so that the cost to the transferee department is not overstated. This method provides a better understanding and reduces conflict of interest between the managers of the transferor and transferee departments.
Significance of Transfer Pricing
Transfer price is significant from the point of view of departments. Although it does not make any effect on the overall profitability of the company because transfer price neutralises the effect of profits generated by the transferor department by cost increased for the transferee department. But the transfer price used shows the efficiency of the transferor department for the generation of profits and also the efficiency of the manager of the transferee department for cost-effectiveness.
If the transfer is at cost, then the efficiency of managers of the transferor as well as the transferee department cannot be evaluated. The manager of the transferor department will always be concerned about transfer pricing which includes costs and higher profits while on the other hand, the manager of the transfer department will be interested in the transfer of product at cost. Therefore the fixing of transfer pricing is a key issue and is considered of great importance in the interest of the company to motivate the managers.