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All you need to know about Market-Based Transfer Pricing

Ruchi Gandhi

| Updated: Mar 22, 2022 | Category: Transfer Pricing in India

Market-Based Transfer Pricing

For corporations with a small number of subsidiaries, simple supply chains, in which commodities are moved from one division to another, function well. But what about large corporations that control a slew of smaller corporations, each of which is responsible for its own accounting? Companies must employ transfer pricing in these instances, which is the process of determining how to charge various divisions for distinct items. Many individuals believe that the optimum pricing system is market-based transfer pricing, which bases items costs on what you’d find on the open market.

What is Market-Based Transfer Pricing?

When it comes to calculating the price that will be paid between divisions of the same organization, market-based transfer pricing is probably the most simple and effective method. It employs the typical market rate, which is the price that would be paid if the commodities were purchased on the open market. As a result, both subsidiaries end up performing in a manner as if they were selling or purchasing items from a third party. If any other strategy is adopted, one subsidiary tends to end up generating more money than it should because the profits of the other are decreased.

Transfer prices are classified into three types based on their transaction basis: market price-based, negotiated, and cost-based transfer pricing. Market-based transfer pricing is oriented to the prices of identical products on an external market, whereas negotiated transfer prices are on the grounds of a negotiation process between the internal business departments involved in the manufacturing process and are thus market price-based as well. Cost-based transfer pricing, on the other hand, is generated from the intermediate product’s production costs. The transaction freedom is also important in addition to this transaction basis for a transfer price system. The transaction freedom specifies whether the selling or purchasing departments are under any internal pressure to provide the goods or purchase; and whether the intermediate product can be supplied from or sold to an outside market.

Transfer pricing based on market prices represent market conditions and so imitates the market-within-the-company concept. Their benefit is that they support and implement company strategy while also allowing performance[1] monitoring of responsibility centres through the use of market-oriented data. A standardized, existing market for the commodity or a substitute is required for this strategy. Firms may compute a market-based transfer price by comparing current market pricing if the corporate division also sells to the market. Moreover, if a comparable competitive product exists as an alternative, they can get transfer pricing from the market.

The goal of determining a transfer price is for management to foster goal alignment among the division managers participating in the transaction. The transfer price is calculated as the sum of two cost components, according to the basic rule. The outlay cost incurred by the department that produces the goods or services to be transferred is the first component. The direct variable costs of the product or service, as well as any other outlay expenditures incurred solely as a result of the transfer, will be considered outlay costs. The opportunity cost suffered by the company as a whole as a result of the transfer is the second component of the general transfer-pricing rule. An opportunity cost is a benefit that is lost as a result of a specific action.

Why use market-based transfer pricing? Its advantages

The word “market price” refers to a price in a market between independent buyers and sellers. Market prices serve effectively as transfer prices when there is a competitive external market for the transferred product. When transferred goods are reported at market pricing, divisional performance is more likely to reflect the division’s true economic contribution to overall company profitability. If the items are unable to be obtained from a division within the corporation, the intermediate product must be purchased from the outside market at the current market price. As a result, divisional profits are expected to be comparable to those computed if the divisions were independent organizations.

As a result, divisional profitability can be directly compared to the profitability of similar enterprises operating in the same sort of company. Managers of both the buying and selling divisions are generally uncertain about trading with each other or with outsiders. No division can gain an advantage at the expense of another. Top management will not be tempted to interfere in a market price issue.

Market pricing is founded on the concept of opportunity costs. The opportunity cost approach indicates that the market price is the correct transfer price. Because the selling division can sell whatever it produces at the market prices, transferring internally at a lesser price would be detrimental to the division.

Likewise, the buying division can always get the intermediate items at the prevailing market price, so it would be unlikely to pay extra for an internally transferred good. Because the lowest transfer price for the selling division is the market price and the maximum price for the purchasing division is also the market price, the only feasible transfer price is the market price.

The market price might be used to settle disputes between purchasing and selling divisions. From the company’s perspective, market pricing is ideal as long as the selling division is running at full capacity. The market pricing does not allow for any gains or losses in the efficiency of the selling division. It lowers administrative costs since the adoption of competitive market prices is devoid of any disagreement, debate, or bias.

Furthermore, transfer prices depending on the market prices are consistent with the ideas of profit centres and investment centres in responsibility accounting. Market-based transfer pricing, in addition to motivating division managers to focus on divisional profitability, assist in demonstrating the contribution of each division to the overall company profit.

Problems associated with market-based transfer pricing

However, there are several difficulties to employing the market pricing technique.

To begin with, if a competitive market pricing does not exist, it may be difficult to find one. Catalogue pricing may only be somewhat related to real sales prices. Market prices fluctuate often. Furthermore, internal selling charges may be lower than those spent if the items were sold to external parties.

Furthermore, the fact that two responsibility centres are part of the same firm suggests that there may be some benefits to being part of the same organization rather than two different companies competing with one another in the market. For example, there may be greater confidence in the internal division’s product quality or delivery reliability. Alternatively, the selling division may manufacture a specialized product for which there are no market equivalents. As a result, using market pricing may not be practical. Another issue with market prices might arise when a selling division is not functioning at full capacity and is unable to sell all of its items.

In addition to the above, distressed market prices can also pose a difficulty. An industry will occasionally face a period of enormous surplus capacity and extremely lower prices. For instance, when gasoline costs rose owing to a foreign oil embargo, market prices for recreational vehicles and powerboats decreased to very low levels for a brief period of time.

In such severe circumstances, basing transfer pricing on market prices might lead to actions that are not in the best interests of the entity as a whole. Based on artificially low distress market pricing, the manufacturing division may be forced to sell or shut the productive resources allocated to creating the product for transfer. Under depressed market conditions, the managing director of the producing division may decide to shift the division into a more profitable product line.

While such a choice may increase the earnings of the division in the near term, it may be detrimental to the company’s overall interests. It may be preferable for the corporation as a whole to avoid divesting itself of any productive resources and to go through the market downturn. To encourage an independent division manager to behave in this manner, some organizations are also making the transfer price on the basis of the long-run average external market price rather than the present (or potentially depressed) market price.

Takeaway

In practice, no one transfer pricing scheme can be recommended for all decentralized businesses since no single transfer price can assist them to achieve all of their aims and objectives. Before deciding on transfer pricing, divisional firms should first identify their aims and priorities. As a result, the transfer pricing strategies used by a specific commercial firm must match the requirements and features of that enterprise and must ultimately be appraised by the decision-making behaviour that it encourages.

Read our Article:A glance through Transfer Pricing Penalties

Ruchi Gandhi

A CA together with MBA (Fin) and M Com, she relishes taking interest in insightful writing in the domain of taxation and finance. She has gained experience as a full-time author and has also served an accounting role in industry.

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