Transfer Pricing

ACCA P5 Advance Performance Management

Transfer pricing is a way of defining a suitable notional price to the goods or services provided by one unit to another of same company so both co-exist and maximize corporate wealth. (Check the article “Model Answer Transfer Pricing”.) If units are located in different countries, the term international transfer pricing is used.

 The extent to which transfer price covers cost and contributes to profit is matter of policy. The policy can be based upon marginal cost, full cost, market price or negotiation. (Check the article “Performance management”.)

General rule of setting transfer price:

Scenario 1: Perfectively competitive market (for commodity type items)

Transfer price = Market price (adjustment for cost not incurred in internal transfer)

Scenario 2: Selling division has surplus capacity (set by negotiation)

Marginal cost of selling unit =< Transfer price =< (Lower of Market price or Marginal revenue of buying division)

Scenario 3: Selling division does not have surplus capacity

(Higher of Market Price, or Marginal cost + Lost contribution) =< Transfer price =< (Lower of Market price or Marginal revenue of buying division)

Methods of transfer pricing:

In perfectly competitive market – Check Scenario 1 above

Cost based approach –

Ø  Marginal cost – transfer at selling divisions direct variable costs (Check the article “Performance management” Example 2)

Ø  Full cost – transfer at selling divisions total costs (Check the article “Performance management” Example3)

Ø  The opportunity cost – If there is no spare capacity in the selling division, it should take account of any losses in contribution because of internal transfer. The opportunity cost should be added to marginal cost – Check Scenario 3 above.

Ø  Marginal cost plus a lump sum – Selling division provide good at marginal cost + fixed periodic charge to cover overheads

Ø  Dual pricing – Selling division uses full cost+ profit and buying division use marginal cost which is reconciled at end of period.

To see how profit position changes with changes in transfer price policies check the article (Check the article “Performance management”.)

ACCA Article: Transfer Pricing

CIMA Article: Performance management

CIMA Article: Model Answer Transfer Pricing