The Transfer Pricing

Transfer pricing is a term used to describe all aspects of inter-company pricing arrangements between related business entities, including transfers of intellectual property; transfers of tangible goods; services and loans and other financing transactions. Transfer pricing refers to the pricing of goods and services within a multi-divisional organization, particularly in regard to cross-border transactions.

In financial sector, transfer pricing is the value placed on transfers within an organization, used as a means of allocating costs to various profit centers. Transfer pricing is used widely in multi-office banks and bank holding companies, serving these important functions: (i) price setting for services performed by business units; (ii) a means of evaluating financial performance by business units; and (iii) determining the contribution to net income by profit centers in the organization.

The large size firms divide their operation very often into product divisions or subsidiaries. Growing firms add new divisions or departments to the existing ones. The firms then transfer some of their activities to other divisions. The goods and services produced by the new division are used by the parent organization. In other words, the parent division buys the product of its subsidiaries. Such firms face the problem of determining an appropriate price for the product transferred from one division or subsidiary to the other. Specifically, the problem is of determining the price of a product produced by one division of the same firm. This problem becomes much more difficult when each division has a separate profit function to maximize. Pricing of infra-firm ‘transfer product’ is referred to as ‘transfer pricing’. One of the most systematic treatments of the transfer pricing technique has been provided by Hirshleifer. We will discuss here briefly his technique of transfer pricing.

a) Transfer pricing with no external market for the intermediate product

suppose there is no external demand for intermediate product produced by a division of an enterprise or when the division producing the intermediate product can sell it only internally to another division of the enterprise. Since we have assumed that one unit of the intermediate product is required to produce one unit of the final product, the quantity produced of the final product is equal to quantity produced of the intermediate product. The figure illustrates the determination of transfer price and output of the intermediate product and price and output of the final product when there does not exist external market for the intermediate product.
Determination of transfer price of the intermediate product with no external market
Dm is the external demand of the final product of the marketing division and MRm is the corresponding marginal revenue curve of the final product. MCm is the marginal cost of the final product processed by the marketing division and MCp is the marginal cost of intermediate product of the production division. By vertical summation of marginal cost curves MCm and MCp we get the total marginal cost MC of the final product. In order to maximize profits, the firm (marketing division) will equate its marginal revenue (MRm) with its total marginal cost (MC) and, as will be seen from figure, its profit-maximizing point is E at which OQ level of output is produced and price Pm of the final product is set. Since by assumption production of one unit of final product requires one unit of intermediate product, the out of the intermediate product by the production division will be equal to the output of the final product. Therefore, the amount OQ of the intermediate product will be produced.

The transfer price for the intermediate product, Pt is set equal to the marginal cost of producing OQ amount of it which is equal to QB. The transfer price Pt equal to marginal cost of production of output OQ of the intermediate product is a right or appropriate transfer price as by adding it to marginal cost (MCm) the marketing division equates the combined marginal cost (MCp + MCm) with its marginal revenue (MRm) to maximize the overall profits of the enterprise. As seen above, this causes the top management of the enterprise to decide to produce OQ output of the final product and set price of the final product equal to PM to maximize overall profits of the enterprise.

b) Transfer pricing with external perfectly competitive market for the intermediate product

The external market in which the intermediate product is sold in perfectly competitive with this the division of the enterprise producing the intermediate product and facing the constant price Opt prevailing in the perfectly competitive external market will equate it with its marginal cost (MCp) to maximize its profits.

Transfer Pricing with External Perfectly Competitive Market for the Intermediate Product
In the figure, price Pt is equal to marginal cost (MCp) of the production division at point E1 and, therefore, it will produce OQp of the intermediate product. This perfectly competitive price of the intermediate product is the right transfer price for the marketing division when there exists external market for the intermediate product. By adding this, transfer price Pt to the marginal cost curve (MCm) of the marketing division, we obtain the total marginal cost MC(MC= MC+ Pt). The marketing or assembling division will equate this total marginal cost MCt with MRm to maximize its profits and, as will be seen from figure, this happens at point E2 which corresponds to price Pm and output OQm.

It follows from above that of the total output Qp produced by the production division producing intermediate product, it will sell Qm units internally to the marketing division and the remaining QmQp it will sell in the external market. In this way, the profits of each unit and the overall profits of the enterprise are maximized.

c) Transfer pricing with imperfectly competitive external market

It is assumed that the external market for intermediate product is imperfectly competitive. It may be noted that imperfectly competitive external market exists when the intermediate products are not homogeneous across firms so that the demand curve for an intermediate product is downward sloping and marginal revenue curve lies below it. Transfer pricing with imperfectly competitive external market is illustrated in figure.

In panel (b), we have drawn the demand (i.e. average revenue) and marginal revenue curves of the intermediate product of the production division of the firm in the imperfectly competitive external market. In panel (a), we have shown the net marginal revenue curve (NMR) of the intermediate product, internally by the firm’s assembling division which sells the finished product in the external market. Note that net marginal revenue (NMR) of the assembling unit of the firm which produces the finished product is obtained by deducting the transfer price of the intermediate product (which is equal to marginal cost of production (MCp) of the production division of the firm) from marginal revenue of the assembling unit (MRa). Thus, in a panel (a) NMR = MRe – MCp. If marginal cost of production (MCp) which forms the transfer price is not subtracted from MRa, of the assembling unit, we would be ignoring production division’s marginal cost of the intermediate product.

Now, in order to determine profit-maximizing output of the intermediate product we have to sum up laterally net marginal revenue curve (NMR) of the internal assembling unit of the firm and marginal revenue curve (MRe) of the intermediate product in the external market. This has been done in panel (c) where lateral summation of NMR and MRe curves yield marginal revenue curve MRp that the production unit (MRp = NMR + MRe). It will be seen from panel (c) of figure that marginal cost of production curve MCp intersects marginal revenue curve MRp of the intermediate product and accordingly output Qp of the intermediate product is produced.

1 comment:

  1. Transfer pricing is a great way to move goods from one company division or department to another without generating a lot of postings on the Accounts Receivable and Accounts Payable books.

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