transfer+pricing

(//By J. Wheeler//)
 * Transfer Pricing**

Transfer pricing is a pricing stategy in which a firm optimally sets contributions that are transferred within an organization. Contributions can include company assets – tangible or intangible, services and funds to name a few. Transfer pricing has many implications which can impacted the overall profit of the firm. First, most firms set organizational unit goals, however, if the firm does not set optimal transfer price of inputs for downstream use then the organizational units may achieve their profit goals (MC=MR), however, this could lead to sub-optimal overall profit of the firm because the upstream units will price their products higher causing overall cost to be greater causing overall firm profit to be lower per unit.

Second, we look at multi-national firms and the implications of transfer pricing. Firms may use transfer pricing as a pricing strategy in which they use cross-border transactions as a tax shelter for their profits. Of course these types of transactions are illegal and this has led to transfer pricing regulations and enforcement. Transfer pricing for multi-national firms are a major tax compliance issue. Most countries enforce tax laws based on the arm’s length principle as defined in the OECD (Organisation for Economic Co-operation and Development). The OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations helps countries define how transfer prices can be set so that they ensure they get their fair share of taxes.

There are several methods of calculating transfer prices; below I will work a simple example of transfer pricing, however, because no two countries are alike nether are their methods. Traditional pricing methods include Comparable Uncontrolled Price method, Cost Plus method and Resale Price method. Non-traditional pricing methods include PS method, TNMM and Comparable Profits Method.


 * In The Real World**

Transfer pricing can be seen in many areas of industry, however, a good example of transfer pricing can be seen auto manufacturing industry. Suppose we worked for Ford in their assembly division for super fast (very expensive) F150 pickup trucks putting engines into the trucks. When we receive an engine from our engine division we don’t just take the engine put in the truck and then sell the truck. Our division has to buy the engine put it into the truck finish the rest of the assembly and then another division takes it from there. At each stage there is a cost associated with taking an input from our up-stream division and using it in the assembly of the truck. That cost is in essence the transfer price between the two divisions. Again remember that when divisions mark up proces in exess of maginal cost, double marginalization occurs and the result is less than optimal overall profits for the firm.


 * Calculating Transfer Prices**

The important equation when looking at transfer pricing is that the Net Marginal Revenue is equal to the downstream marginal revenues minus the downstream marginal costs which in turn also equals the marginal cost of the upstream division.

NMRd = MRd - MCd MCu

So to see a simple example lets take a look at our Ford engines. Suppose that our demand for engines in assembly is P =46,000 – Q. Our engine division produces engines at a cost of Cu(Qe) 5Q2, and our cost of asembling the F150 truck is Cd(Q) 10,000*Q. Our assembly marginal revenue and marginal cost are MRd 46,000-2Q and MCd 10,000. Our engine division’s marginal cost is MCu 10Qe. Using our net marginal revenue formula we get:

NMRd = 46,000 – 2Q – 10,000 10Qe

To maximize overall profits the engine division should produce 3000 engines. The optimal transfer price (MRd – MCd = MCu) then is (46,000 – 2(3000) – 10,000) $30,000 per unit.


 * Questions**

1. The goal of transfer pricing is to maximize a. The upstream divisions profits b. The downstream divisions profits c. The overall Firms profits d. None of the above

2. Transfer pricing is only relevant to the United States a. True b. False

3. Most countries follow which rule when creating regulation on transfer pricing policy a. hands length rule b. section 272 of the IRS corporate transfer policy c. no rules d. arms length rule

4. Transfer pricing can be used as a legal tax shelter for large multi-national firms a. True b. False

5. Who defined the arms length principle? a. IRS b. European Union c. OECD d. None of the above

Answers.

1.) A - The goal of transfer pricing is to maximize the firms overall profit 2.) B – Most countries enforce some sort of policy regarding transfer pricing 3.) D – Because every country is a little different in how they defined transfer pricing most countries follow the arms length rule to ensure they get the fair share of taxes. 4.) B – False, Most countries have policies in place to prevent the use of transfer pricing as a tax shelter. 5.) C - The OECD (Organization for Economic Co-operation and Development) defined the arms length rule


 * Works Cited**

Abdel-Khalik, A.R., Lusk, E.J. "Transfer Pricing-A Synthesis" The Accounting Review, Vol. 49, No. 1. (Jan., 1974), pp. 8-23.

Alles, M, Datar, S. "Strategic Transfer Pricing" Management Science, Vol. 44, No. 4. (Apr., 1998), pp. 451-461.

Baye, Michael. "Coordination Decision" //Managerial Economics and Business Strategy// 5th Ed, McGraw-Hill Irwin, Burr Ridge, IL

Unknown Author. "Transfer Pricing" //Wikipedia.org// Accessed on 5/22/07 http://en.wikipedia.org/wiki/Transfer_pricing