Transfer pricing is the method used to sell a product from one subsidiary to another within a company. This approach is used when the subsidiaries of a parent company are measured as separate profit centers. Transfer pricing impacts the purchasing behavior of the subsidiaries, and may have income tax implications for the company as a whole. Here are the key issues:
Revenue basis. The manager of a subsidiary treats it in the same manner that he would the price of a product sold outside of the company. It forms part of the revenue of his subsidiary, and is therefore crucial to the financial performance on which he is judged.
Preferred customers. If the manager of a subsidiary is given the choice of selling either to a downstream subsidiary or to outside customers, then an excessively low transfer price will lead the manager to sell exclusively to outside customers, and to refuse orders originating from the downstream subsidiary.
Preferred suppliers. If the manager of a downstream subsidiary is given the choice of buying either from an upstream subsidiary or an outside supplier, then an excessively high transfer price will cause the manager to buy exclusively from outside suppliers. As a result, the upstream subsidiary may have too much unused capacity, and will have to cut back on its expenses in order to remain profitable.
Conversely, these issues are not important if corporate headquarters uses a central production planning system, and requires upstream subsidiaries to ship components to downstream subsidiaries, irrespective of the transfer price.
An additional topic that impacts the overall level of corporate profitability is the total amount of income taxes paid. If a company has subsidiaries located in different tax jurisdictions, it can use transfer prices to adjust the reported profit level of each subsidiary. Ideally, the corporate parent wants to recognize the most taxable income in those tax jurisdictions where corporate income taxes are lowest. It can achieve this by lowering the transfer prices of components going into the subsidiaries located in those tax jurisdictions having the lowest tax rates.
A company should adopt those transfer prices that result in the highest total profit for the consolidated results of the entire entity. Almost always, this means that the company should set the transfer price to be the market price of the component, subject to the issue just noted regarding the recognition of income taxes. By doing so, subsidiaries can earn more money for the company as a whole by having the option to sell to outside entities, as well as in-house. This gives subsidiaries an incentive to expand their production capacity to take on additional business.
Transfer Pricing Methods
Here are a number of ways to derive a transfer price:
Market rate transfer price. The simplest and most elegant transfer price is to use the market price. By doing so, the upstream subsidiary can sell either internally or externally and earn the same profit with either option. It can also earn the highest possible profit, rather than being subject to the odd profit vagaries that can occur under mandated pricing schemes.
Adjusted market rate transfer price. If it is not possible to use the market pricing technique just noted, then consider using the general concept, but incorporating some adjustments to the price. For example, you can reduce the market price to account for the presumed absence of bad debts, since corporate management will likely intervene and force a payment if there is a risk of non-payment.
Negotiated transfer pricing. It may be necessary to negotiate a transfer price between subsidiaries, without using any market price as a baseline. This situation arises when there is no discernible market price because the market is very small or the goods are highly customized. This results in prices that are based on the relative negotiating skills of the parties.
Contribution margin transfer pricing. If there is no market price at all from which to derive a transfer price, then an alternative is to create a price based on a component’s contribution margin.
Cost-plus transfer pricing. If there is no market price at all on which to base a transfer price, you could consider using a system that creates a transfer price based on the cost of the components being transferred. The best way to do this is to add a margin onto the cost, where you compile the standard cost of a component, add a standard profit margin, and use the result as the transfer price.
Cost-based transfer pricing. Have each subsidiary transfer its products to other subsidiaries at cost, after which successive subsidiaries add their costs to the product. This means that the final subsidiary that sells the completed goods to a third party will recognize the entire profit associated with the product.
Transfer Pricing Example
Entwhistle Electric makes compact batteries for a variety of mobile applications. It was recently purchased by Razor Holdings, which also owns Green Lawn Care, maker of low-emission lawn mowers. The reason for Razor’s purchase of Entwhistle was to give Green an assured supply of batteries for Green’s new line of all-electric lawn mowers. Razor’s corporate planning staff mandates that Entwhistle set a transfer price for batteries shipped to Green that equals its cost, and also requires that Entwhistle fulfill all of Green’s needs before it can sell to any other customers. Green’s orders are highly seasonal, so Entwhistle finds that it cannot fulfill orders from its other customers at all during the high point of Green’s production season. Also, because the transfer price is set at cost, Entwhistle’s management finds that it no longer has a reason to drive down its costs, and so its production efficiencies stagnate.
After a year, Razor’s corporate staff realizes that Entwhistle has lost 80% of its previous customer base, and is now essentially relying upon its sales to Green to stay operational. Entwhistle’s profit margin has vanished, since it can only sell at cost, and its original management team, faced with a contracting business, have all left to work for competitors.