Transfer Pricing in India

An overview of Cost-based transfer pricing

Companies encourage intra-company commerce and purchasing between divisions in order to optimize profits and improve competition. The transfer price is the price of moving goods from one division to another. You can configure the price as market-based, cost-based, or negotiated pricing, depending on the type of goods exchanged and their availability in the external market. In this blog, we will look at cost-based transfer pricing, its types, and how it compares to other pricing options.

Cost-based transfer pricing

Companies typically have many subsidiaries, which necessitate the transfer of products and services back and forth. However, one can’t merely let products vanish or reappear on balance sheets at random. Instead, there must be a means to show where the transfer has originated from. Of course, nothing comes for free, and you’ll come across a term called a transfer price, which refers to the cost of moving products inside a corporation. There are several forms of transfer pricing, and some businesses may be inclined to adopt cost-based transfer pricing. Only one subsidiary pays the cost of producing the commodities it buys from another subsidiary in cost-based transfer pricing. This sometimes increases earnings for one division of the company while destroying profitability for the other.

When selling items to divisions within the same corporation, cost-based transfer pricing is a way of determining prices. Production expenses, manager evaluations, taxation, and competitor price are all elements that influence the price.

Types of cost-based transfer pricing methods

If external markets do not exist or when they are not accessible to the organization, or when information regarding external market prices is not easily available, companies may choose to employ some type of cost-based transfer pricing mechanism. Cost-based transfer pricing can take several forms, including variable cost, actual full cost, full cost + profit margin, and standard full cost.

Variable cost

When the selling division is running at less than full capacity, the variable cost-based pricing technique comes in handy. This transfer price is often disliked by the management^[1] of the selling division since it generates no profit for that division. Only variable manufacturing costs are transferred in this pricing method. Direct materials, direct labor cost, as well as variable production overhead are included in these expenses.

The main advantage of variable costs is that they encourage maximum profitability for the whole organization. By transferring only variable costs to the next division, production and price considerations for the business as a whole are based on cost-volume-profit relationships. The apparent issue is that the selling division is responsible for all fixed expenditures and operational expenses. That division is currently a loss division, far from being a profit center.

Actual full cost

The transfer price in the actual full cost method is determined by the whole product cost per unit, which includes direct materials, direct labor, and factory overhead. The selling division cannot make a profit on the products transferred when the full cost is applied for transfer pricing. This might be a deterrent to the sales division. Furthermore, full cost transfer pricing has the potential to create perverse incentives and skew performance metrics. Any potential of divisions negotiating about selling at transfer prices would be eliminated if the full cost transfer price is been used by a company.

Full cost + profit margin

The full cost-plus markup (or profit margin) approach compensates for the shortcomings of the full cost basis transfer pricing system. The total cost-plus pricing comprises the item’s permitted cost as well as a mark-up or other profit margin. The selling division receives a profit contribution on units transferred under this method, and hence benefits if success is judged in terms of divisional operating profits. The manager of the purchasing division, on the other hand, would understandably resent that his expenses (and hence reported performance) are impacted.

The fundamental question in full cost-plus mark-up is ‘what proportion of mark-up should there be?’ It is recommended that the mark-up percentage meet operational expenditures while also providing a target return on sales or assets.

Standard full cost

Because the cost of manufacturing a product might fluctuate due to human error or operational issues, determining the item’s standard cost is the simplest approach to calculate a cost-based transfer price. The typical or expected cost of manufacturing a product under normal conditions is known as standard cost.

Standard costs are used by businesses to include in their operational budgets and profit projections, to forecast the upcoming fiscal year, to review the company’s performance, and to decide if they are on track to accomplish their objectives.

There is an issue with quantifying cost in actual cost techniques. Actual cost provides little motivation for the selling division to keep costs under control. All product expenses are passed on to the purchasing division. Any discrepancies or inefficiencies in the selling division are also passed on to the buying division while transferring actual expenses.

Isolating deviations that have been transferred to the consecutive buyer divisions becomes a very difficult challenge. Therefore, standard costs are typically used as a foundation for transfer pricing in cost-based systems to promote accountability in the selling division and to identify the differences/deviations within divisions.

Standard costs, when available, are frequently used as the foundation for transfers, whether at differential costs or full costs. Because inefficiencies are not passed on to the purchasing division, this increases efficiency in the selling division. Otherwise, cost inefficiencies in the selling division might be passed on to the buying division. The buyer’s risk is decreased when standard costs are used. The buyer is aware that normal costs shall be transferred and thereby avoids being overcharged for cost overruns by suppliers.

Pros and cons of cost-based transfer pricing

The following are the two key advantages of using cost-based transfer pricing for a company:

• It helps the organization in achieving high profitability by basing the pricing and production decisions on how price impacts sales on a cost-volume-profit basis. This strategy boosts the return on investment, allowing the purchasing division to break even more quickly.
• It is straightforward and easy since the pricing is normally established at the total manufacturing cost, which means that selling divisions cannot profit, and the buying division is already aware of the pricing based on how much does it cost to produce.

Other benefits of cost-based pricing are as follows:

• It comes in handy for pricing low-risk and creative goods.
• Accounting officials might use it to make evaluation judgements. Using the right return on investment (ROI) figures, for example.
• Cost-based transfer pricing helps to assure that all incurred expenditures are recovered by monitoring the cost of production.

On the other hand, some drawbacks of cost-based pricing are as follows:

• The strategy does not include any incentives.
• In the external market, the company loses the ability to demand a greater price.
• It fails to take into account the influence of supply and demand dynamics.

Comparison with market-based transfer pricing

When the information of the external market is unavailable during the trading stage, cost-based transfer pricing is beneficial; however, market-based transfer pricing is more practical to apply when your product is competitive in the external market. When transferred commodities are recorded at market pricing, divisional performance is more likely to indicate the division’s actual contribution to the overall corporate earnings.

If a division of a firm is unable to purchase a product from another division, it will be forced to purchase it on the open market at the current market price. Assuming as if the divisions were from different corporations, the divisional earnings would then be the same as the calculated profits.

Comparison with negotiated transfer pricing

When opposed to both cost-based and market transfer pricing, negotiated transfer pricing is a middle way in which the selling and buying divisions agree on the optimal price for both, under the supervision of senior management. The two of them bargain at arm’s length and determine whether to sell or purchase from the external market or trade among themselves. The negotiated transfer pricing strategy, unlike the cost-based transfer approach, avoids divisional disputes and, like market-based transfer pricing, fosters divisional profit maximization.

Takeaway

Market-based, cost-based, and negotiated methods can all be used to calculate transfer pricing. The transfer price can be established using the cost-based method, which includes a variety of methodologies, and can be based on the production cost plus a markup if the upstream division wants to make a profit on internal sales.

Read our Article:A glance through Transfer Pricing Penalties