An insight into Negotiated Transfer Pricing

Ruchi Gandhi

09 Jun, 2022

Negotiation between the purchasing and selling divisions might determine the transfer price. This would be reasonable if it could be anticipated that such discussions would lead to conclusions that were in the best interests of the company as a whole and were acceptable to all parties involved.

What is “negotiated transfer pricing”?

Negotiated transfer pricing refers to when a firm’s representatives negotiate prices on their own, rather than relying solely on market prices. It may be required to negotiate a transfer price between subsidiaries without referring to any market pricing as a starting point. Because the market is small or the items are highly tailored, this situation emerges when there is no obvious market price. As a result, the parties’ respective negotiation abilities determine the price.

Negotiated pricing is widely recommended as a compromise between market and cost-based pricing. The managers who engage in negotiated prices behave similarly to managers of independent businesses. Negotiation methods are likely to be similar to those used when dealing with external markets. The negotiated price will most probably be close to the external market price if both the divisions are free to interact with each other or in the external market. In case all of a selling division’s goods cannot be sold in the external market (i.e., a portion must be sold to the purchasing division), the negotiated price will almost certainly be lower than the market price, and the entire margin will be divided by the divisions.

When the firm uses negotiated transfer pricing, the managers who are engaged in the planned transfer meet to discuss the terms and circumstances of the transfer. They have the option of not proceeding with the transfer, but if they do, they must agree on a transfer price. In general, one would be unable to forecast the precise transfer price they will accept. However, one can reliably anticipate two things: (1) the selling division will agree to transfer only if the selling division’s profits increase as a consequence of the transfer, and (2) the purchasing division will agree to transfer only if the buying division’s profits improve as a result of the transfer. This may appear apparent, yet it is a critical aspect.

Obviously, if the transfer price is less than the selling division’s cost, the transaction will be a loss, and the selling division will refuse to consent to the transfer. On similar grounds, if the transfer price is set too high, the buying division will be unable to earn a profit on the transferred product. The transfer price for each particular proposed transfer has both a lower limit (decided by the condition of the selling division) and a higher limit (decided by the situation of the buying division). The actual transfer price agreed upon by the two division managers might be anything in between these two ranges. These restrictions define the permissible transfer price range, i.e., the price range within which both divisions involved in a transfer would see a profit/gain in earnings.

The below-mentioned requirements must be met for a negotiated transfer price to be successful:

• There should be an outside market for the intermediary product. This prevents a bilateral monopoly situation in which the ultimate price might fluctuate over a wide range based on the power and ability of each negotiator.
• All market data should be shared among the negotiators. As a result, the negotiated price should be close to the opportunity cost of one or, ideally, both divisions.
• It should be possible to buy and sell outside. This gives the negotiation process the essential discipline.
• Top management must provide support and participate on an as-needed basis. The parties must be encouraged to resolve most problems on their own, or the benefits of decentralization will be lost. Top management must be present to mediate the rare unresolved issue or to step in when the negotiating process visibly leads to inferior conclusions. However, such participation must be done with caution and discretion so as not to jeopardize the bargaining process.

Pros and cons of negotiated transfer pricing

Transfer prices that are negotiated offer a number of significant advantages. First, this strategy respects the autonomy of the divisions and is compatible with the idea of decentralization. Second, the divisional managers are likely to have far more knowledge about the possible costs and advantages of the transfer than the rest of the organization.

Mistrusts, unpleasant sentiments, and unfavorable negotiating interests among divisional managers are all avoided when a price is negotiated. It also allows for the attainment of the objectives of goal alignment, autonomy, and accurate performance assessment. If the selling and purchasing divisions can come to an agreement on certain mutually transferable prices, the organization as a whole will benefit. Negotiated transfer prices are viewed as an important integrating tool across a company’s divisions since they are required to achieve goal congruence.

If negotiations assist to guarantee that goals are aligned, senior management is less likely to intervene between divisions. Without causing any friction, the negotiated pricing can also be used to monitor performance. In divisional enterprises, the use of negotiated pricing is compatible with the idea of decentralized decision-making.

On the other hand, there may be some drawbacks to negotiated transfer pricing. These are as follows:

• The negotiation process may occupy a lot of management time, effort, and resources.
• The competence and talent of the divisional manager to bargain may have a greater impact on the final agreed price than the other criteria. As a result, performance measurements will be skewed, resulting in an inaccurate assessment of divisional performance.
• One divisional manager may take advantage of another divisional manager if he or she has access to confidential information.
• It takes a lot of time for the management involved.
• It results in divisional conflicts.
• If the agreed price is higher than the opportunity cost of delivering the transferred products, it may result in a suboptimal level of output.

Considerations in choosing a transfer pricing technique

The method or technique by which transfer prices are set is determined by the firm’s management and can be any of these broad systems, namely cost-based, negotiated, or market-based transfer pricing. Some considerations might be kept in mind while selecting an appropriate transfer pricing method.

Where there is a competitive market for the intermediate product, the market price, minus selling, distribution, and collecting charges for external clients/customers, reflects an excellent transfer price.

Where an external market exists for the intermediate product but is not fully competitive, and where only a few different items are transferred, a negotiated-transfer-price method is likely to function well, because the outside market price can serve as an indication of the opportunity cost. At least occasional interactions with outside suppliers & customers are required if both divisions are to have credibility in the negotiation process and if trustworthy bids from external enterprises are to be received.

In addition, when there is no external market for the intermediate product, transfers should take place at the long-run marginal cost of production. This cost will help the buying division make decisions by providing the consistency needed for long-term planning while also exposing the cost structure so that short-run improvements and modifications may be made. The marginal cost estimate includes a periodic fixed charge based on the capacity allotted for the purchasing division.

The fixed charge should apportion the facility’s capacity-related expenses in proportion to each user’s intended usage of the facility’s resources, preferably based on the product and facility-sustaining costs from an ABC model. The fixed charge encourages the purchasing division to account for the entire cost of the resources needed to create the intermediate product internally, and it encourages the producing divisions to work together in determining the appropriate degree of production capacity to acquire.

There are no observable desirable qualities in a transfer price based on completely allocated costs per unit (using current, that is, non-ABC methods of allocation) or full cost-plus markup. Despite having minimal economic merit, the full-cost transfer price is nonetheless extensively employed. Managers can utilize a full-cost method that is compatible with economic theory using the marginal cost determined using an ABC model.

Conclusion

The conversations between the selling and buying divisions result in negotiated transfer pricing. If the transfer has no effect on fixed costs, the transfer price must cover both the variable costs of manufacturing^[1] transferred units as well as any opportunity costs from the selling division’s perspective. Only if the purchasing division’s profit grows will it be interested in the proposition. If a buying division or segment has an outside supplier, the decision is straightforward. If the price given by the inside provider of goods is lower than the price offered by the outside supplier, then it would purchase from them (i.e., inside supplier).

Read our Article:Some Important Transfer Pricing Case Laws in International Taxation