Transfer pricing and business issues
Transfer pricing decisions are influenced by several business considerations that affect the feasibility, fairness, and profitability of internal transactions. Key factors include:
- presence of outside suppliers
- capacity of the supplying division
- practical limits of transfer prices.
Presence of outside suppliers
The availability of outside suppliers introduces an external benchmark for assessing the appropriateness of internal transfer prices. If external suppliers offer similar goods or services at lower prices or on better terms, the receiving division may find it more cost-effective to purchase externally. This competitive pressure encourages internal divisions to improve efficiency and ensure that transfer prices remain competitive. Relying on external suppliers, however, can reduce synergy within the organization, and the decision must balance cost considerations with strategic goals, such as maintaining internal collaboration.
Capacity of the supplying division
The capacity of the supplying division is another critical factor in transfer pricing. When the supplying division has excess capacity, selling internally does not impact its ability to meet external demand. In this situation, the transfer price is often set closer to the variable cost of production, as the goal is to utilize idle resources efficiently. On the other hand, when the supplying division operates at full capacity, fulfilling internal demand may require diverting resources from external sales. This scenario introduces an opportunity cost, as the supplying division sacrifices potentially higher revenues from external sales to meet internal demand. Consequently, the transfer price in such cases should reflect the lost opportunity: typically the market price, minus any selling costs the supplying division saves by selling internally. The transfer price should never exceed the market price, since a higher price would simply push the buying division to an outside supplier.
In general, the minimum acceptable transfer price equals variable cost plus opportunity cost - the per-unit contribution margin given up on the forgone external sale. With excess capacity, that opportunity cost is zero.
Practical limits of transfer prices
The practical limits of transfer prices are defined by the ceiling and floor. The ceiling is the external market price of the product - prices above this level make external procurement more advantageous for the receiving division. The floor is the supplying division’s minimum acceptable price: variable cost plus any opportunity cost. With excess capacity, there’s no opportunity cost, so the floor equals variable cost. At full capacity, the floor equals the market price minus any selling costs avoided on internal sales. A transfer price below the floor leaves the supplying division worse off than if it had sold externally or not produced at all.
Example: Transfer price range
A supplying division has a variable cost of $30 per unit. The buying division could purchase the same product from an outside supplier for $50 per unit, which sets the ceiling. Selling internally instead of externally saves the supplying division $2 per unit in selling costs.
- With excess capacity: no outside sale is given up, so the floor is simply variable cost: $30.
- At full capacity: each unit transferred internally replaces an external sale, so the floor is market price minus the avoided selling costs: $50 − $2 = $48.
- Ceiling: $50, the price the buying division would otherwise pay an outside supplier.
Answer: The negotiable transfer price range is $30-$50 with excess capacity, narrowing to $48-$50 at full capacity.
Transfer pricing in multinational corporations
Transfer pricing in multinational corporations (MNCs) involves setting prices for goods or services exchanged between divisions located in different countries. Unlike domestic transactions, these transfers face additional challenges due to differences in economic conditions, regulations, and operational environments across borders.
Several key factors influence transfer pricing and the evaluation of divisional performance in MNCs, including:
- tariffs
- exchange rates
- taxes
- currency restrictions
- expropriation risk
- availability of materials and skills
Tariffs
Tariffs are taxes on imports imposed by governments. When divisions in different countries transfer goods, tariffs can increase costs. To reduce this burden, MNCs may adjust transfer prices to lower the value of goods entering high-tariff countries.
Exchange rates
Exchange rates determine the value of one country’s currency compared to another and often fluctuate. For MNCs, these fluctuations change the local-currency value of a transfer price that’s set in a foreign currency. For example, if the transfer price is set in the buying division’s currency and the selling division’s currency strengthens, each unit converts into less local currency, so the seller’s reported revenue falls; a weakening seller currency has the opposite effect.
Taxes
Countries have different tax rates, and MNCs often set transfer prices to optimize their overall tax burden. For example, by shifting profits to countries with lower tax rates, companies can reduce their total tax expense. However, tax authorities closely monitor this practice, and MNCs must ensure their transfer pricing complies with international tax laws to avoid penalties or disputes.
Currency restrictions
Some countries limit the transfer of money across borders. These restrictions, called currency controls, can make it difficult for MNCs to move profits between divisions in different countries. To get funds out, MNCs may charge high transfer prices on goods and services shipped into the restricted country, so cash flows out as payments for those goods rather than as restricted profit remittances.
Expropriation risk
Expropriation risk refers to the possibility of a government taking control of a company’s assets. In countries with this risk, MNCs may set low transfer prices on goods the local division sells to affiliates and high prices on goods it buys from them. This keeps reported profits and assets in that country low.
Availability of materials and skills
The cost of materials and labor varies across countries. For example, a division in a country with expensive raw materials or higher wages may have higher production costs. Transfer prices need to reflect these differences.
Across all these factors, adjusting transfer prices for tax, currency, risk, or cost reasons can distort reported divisional profits, so performance evaluations should account for these effects separately rather than take reported profit at face value.