The transfer pricing problem

Profit (or investment) centers often supply products or services to other profit centers within the
same firm. When that happens, some mechanism for determining the prices of the transfers must
be established.10Transfer prices directly affect the revenues of the selling (supplying) profit
center, the costs of the buying (receiving) profit center and, consequently, the profits of both
entities, thus essentially making transfer prices subject to “zero-sum” considerations (that is,
more revenue for one is more cost for the other). The impact of these transfer prices depends
largely on the number and magnitude of internal transfers relative to the size of each entity.
When the amount of transfers is significant, failure to set the right transfer prices can signifi-
cantly affect a number of important decisions, including those regarding production quantities,
sourcing, resource allocations, and evaluations of the managers of both the selling and buying
profit centers. Put simply, when this is the case, it ups the stakes in the zero-sum game among
the transferring entities
Purposes of transfer pricing
Transfer prices have multiple organizational purposes, and these purposes often conflict. One
purpose of transfer prices is to provide the proper economic signals so that the managers affected
will make good decisions. In particular, the prices should properly influence both the selling
profit center managers’ decisions about how much product/service to supply internally and the
buying profit center managers’ decisions about how much product/service to buy inter-nally.
Ideally, then, the decisions that the transferring entities make should be “optimal” not only at
their own entity level, but also for the corporation as a whole. Ill-devised transfer prices often do
not achieve a global optimum even while being locally optimal – for example, because they
cause the buying profit centers to source externally while there is excess capacity for the inputs
in the supplying entities elsewhere in the corporation.Second, the transfer prices and subsequent
profit measurements should provide information that is useful for evaluating the performances of
both the profit centers and their managers. Transfer prices directly affect the profits of both the
selling and buying entities. Ideally, the transfer prices should not cause the performance of either
entity to be either over- or under-stated. Misleading profitability signals can adversely affect
allocations of resources within the firm, thus rendering them suboptimal. They can also severely
undercut profit center managers’ motivations because the managers will argue that they are not
being treated fairly.Third, transfer prices can be set to purposely move profits between firm
locations. Several factors can motivate managers to use transfer prices in this way. When firms
are operating in multiple tax jurisdictions (countries or states), their managers might be
motivated to use trans-fer prices to move profits between jurisdictions to minimize taxes.
Corporate income tax rates differ significantly across countries, and managers can set transfer
prices to earn profits in rela-tively low-tax localities to maximize after-tax worldwide profits.
Although this particular aspect of the transfer pricing problem is beyond the scope of this
chapter, evidence suggests that the maximization of global profits remains a critical
consideration of transfer pricing poli-cies in multinational corporations. Clearly, such transfer
pricing arrangements that deter-mine how firms’ taxable profits are “allocated” between
countries is politically controversial. They often make headlines in the press, where Apple,
Google, Starbucks, Fiat, and other big-name companies are chastised as tax dodgers, irking their
customers and damaging their repu-tations as socially responsible corporations.12Profit
repatriation limitations also may encourage companies to use transfer prices to move profits
between entities across country borders. For a number of reasons, including balance of payments
problems and a scarcity of foreign currency reserves, some governments prohibit repatriation of
profits, either directly or indirectly. Indirect forms of restrictions include dis-torted exchange
rates or high withholding tax rates. When companies are unable to repatriate profits from their
entities in foreign countries, they are motivated to set transfer prices to mini-mize profits in those
countries. Companies also sometimes set transfer prices to shift profits between wholly owned
subsidi-aries and entities where the profits are shared with, say, joint venture partners. As a
matter of fact, transfer prices are for this reason often strictly included and set out in great detail
in the joint venture contract to avoid possible expropriation. Sometimes transfer prices are set to
move profits to an entity being positioned for divestment in hopes of increasing its valuation and,
hence, its selling price.These multiple transfer pricing purposes often conflict.13 Except in rare
circumstances, tradeoffs are necessary because no single transfer pricing method serves all the
purposes well. The usual desire to have transfer pricing mechanisms operate automatically
between entities, without frequent interventions from corporate management, provides another
transfer pricing complication. Transfer pricing interventions undermine the benefits of
decentralization. They reduce profit center (entity) autonomy and cause decision-making
complexity and delay. They also increase organizational costs, particularly in terms of the
management time needed to review the facts and to reach a transfer pricing “ruling” acceptable
to all entities involved. Thus, firms seek to set transfer pricing policies that work without
producing major exceptions and disputes.
Transfer pricing alternatives
Most firms use any of five primary types of transfer prices. First, transfer prices can be based on
market prices. The market price used for internal transfers could be the listed price of an
identical (or similar) product or service, the actual price the selling entity charges external
customers (perhaps less a discount that reflects lower selling costs for internal customers), or the
price a competitor is offering. Second, transfer prices can be based on marginal costs, which are
approximated as the variable or direct cost of production. Third, transfer prices can be based on
the full costs of providing the product or service. Both marginal and full cost-based transfer
prices can reflect either standard or actual costs. Fourth, transfer prices can be set at full cost plus
a markup. Finally, transfer prices can be negotiated between the managers of the selling and
buying profit centers. Information about market prices and either marginal or full production
costs often provide input into these negotiations, but there is no requirement that they do so.On
balance, surveys of practice across sources and time seem to suggest that transfers at marginal
cost are rarely used and that most companies internally transfer goods or services at either
market prices or variations of full costs (e.g. full cost plus markup). In other words, what
emerges is that both market price and “cost-plus” methods are the most widely used. Perhaps due
to the increased scrutiny and enforcement by the tax authorities of the presumed arm’s-length
principle (see below), most companies use market-based transfer prices for international transfers
more often than either cost-based or negotiated transfer prices.15 We discuss each of the transfer
pricing methods next
Market-based transfer prices
In the relatively rare situation where a perfectly (or at least highly) competitive external market
exists for internally traded goods or services, it is optimal for both decision-making and
performance evaluation purposes to set transfer prices at competitive market prices. A perfectly
competitive market exists where the product is homogenous and no individual buyer or seller can
unilaterally affect its price.The case for using market-based transfer prices under competitive
conditions is apparent. If the selling profit center cannot earn a profit by selling at the external
market price, then the firm is better off shutting that profit center down and buying from an
outside supplier, all else equal. Similarly, if the buying profit center cannot earn a profit by
buying its inputs at the pre-vailing market price, then the firm should shut that profit center down
and have its selling profit center sell all its outputs to outsiders in the market. Hence, if transfer
prices are set at market price, managers of both the selling and buying profit centers are likely to
make decisions that are optimal from the firm’s perspective, and reports of both of their
performances will provide good information for evaluation purposes.Entities within
organizations, however, rarely operate as they would as stand-alone firms in the open
market.Therefore, many firms use quasi market-based transfer prices by allowing deviations
from the observed market prices. The deviations allow for adjustments that reflect differences
between internal and external sales. These differences can reflect the savings of marketing,
selling and collecting costs, the costs of special terms offered only to external customers (e.g.
warranties), or the value of special features, special services provided, or differences in quality
standards. Adjustments in market prices also may reflect the belief that the price quoted by the
external supplier is not a sustainable competitive price. The price quoted might just be a low-ball
bid designed merely to get the first order. The greater the number and size of these adjustments,
however, the more the market-based transfer prices are like cost-based prices, and the more
difficult the transfer pricing tradeoffs become