What is Transfer Pricing | Transfer Pricing Methods | CMA | CIMA | CA | ACCA | Commerce Specialist |

Summary

This video script delves into the concept of transfer pricing, using a car manufacturing company as an example to illustrate how departments within the same company can set prices for goods transferred between them. It discusses the importance of autonomy in decision-making, factors influencing transfer pricing such as capacity, outside demand, and market price, and provides tips for determining minimum and optimal transfer prices. The script also covers different types of transfer pricing strategies, including variable cost, full cost, cost plus, market price, and negotiated pricing, offering valuable insights for those studying or working in commerce.

Takeaways

• 😀 Transfer pricing is a concept that allows departments within the same company to negotiate prices for goods and services they exchange with each other.
• 🏢 The purpose of transfer pricing is to give autonomy to different departments, allowing them to decide whether to buy internally or from an external supplier.
• 🔄 An example is given where Department A makes tires for Department B's cars, and the quality and cost of the tires affect the final product's marketability.
• 💰 The transfer price should ideally be set considering the market price, capacity, and external demand for the product.
• 📈 If there's unlimited external demand and capacity to meet it, the transfer price should reflect the market price to ensure both departments are satisfied.
• 🚫 If there's no external demand, the minimum transfer price should cover at least the variable costs to avoid losses.
• 📉 In situations where external demand exceeds capacity, the transfer price should account for the lost contribution from not selling to external customers.
• 📚 The script suggests that for exam purposes, remember that the minimum transfer price is the variable cost, and the most reasonable price is the market price.
• 📉 The concept of contribution margin is introduced, which is the difference between the selling price and the variable cost, and it's important when setting transfer prices.
• 🛍 Different types of transfer pricing methods are mentioned, such as variable cost, full cost, cost plus, market price, and negotiated transfer pricing.
• ⚠️ The video ends with a caution to subscribe to the channel for timely updates and a reminder that transfer pricing has various methods and considerations.

Q & A

What is transfer pricing?

Transfer pricing is the method by which the price of goods or services is set when they are exchanged between different departments or divisions within the same company.

Why is transfer pricing important for a company?

Transfer pricing is important as it gives autonomy to different departments within a company to decide whether to buy from an internal source or an external supplier, based on quality and cost considerations.

What is the example given in the script to explain transfer pricing?

The script uses the example of a company with two departments, A and B, where department A manufactures tires and department B assembles cars. Transfer pricing is used to determine how much department B should pay for the tires made by department A.

What are the two main factors to consider when setting a transfer price?

The two main factors to consider when setting a transfer price are the capacity of the producing department and the outside market demand for the product.

What is the minimum transfer price that should be charged according to the script?

The minimum transfer price to charge is the variable cost of production, which is the cost that varies with the level of output.

What is the best transfer price according to the script?

The best transfer price, which keeps both department managers happy, is usually the market price of the product.

What happens if there is unlimited outside demand for the product?

If there is unlimited outside demand, the transfer price should ideally be set at the market price, as the producing department could sell the product to external customers at that price.

What should be the transfer price if there is no outside demand for the product?

If there is no outside demand, the transfer price should at least cover the total cost of production, and ideally, it should be set at the market price if the product was being sold externally.

What is the impact of distribution costs on the transfer price?

Distribution costs should be considered in the transfer price. If selling internally saves on distribution costs, this saving can be factored into the transfer price to make it more favorable for the internal customer.

What is the contribution lost if internal supply leads to forgoing external sales?

The contribution lost is the difference between the market selling price and the variable cost per unit of the product that is not sold externally due to the internal transfer.

What are the different types of transfer pricing methods mentioned in the script?

The script mentions several types of transfer pricing methods including variable cost, full cost or absorption cost, cost plus, market price, negotiated transfer pricing, and arbitrary transfer pricing.

Outlines

00:00

🚗 Introduction to Transfer Pricing and Its Impact on Internal Company Departments

This paragraph introduces the concept of transfer pricing, which is a relatively new and interesting topic in commerce. The speaker uses an example of a company with two departments, A and B, which are involved in the manufacturing and assembly of cars, respectively. Department A produces tires that are transferred to Department B for car assembly. The issue arises when the quality of the tires affects the sales of the final product. The introduction of transfer pricing gives autonomy to both departments, allowing them to decide whether to continue internal transactions or to seek external suppliers. The paragraph sets the stage for a deeper discussion on how to determine the transfer price by considering factors such as production costs, capacity, and market demand.

05:02

💰 Determining Transfer Prices Based on Capacity and Market Demand

The second paragraph delves into how to determine the transfer price by considering the capacity of Department A to produce tires and the market demand for those tires. It presents a scenario where Department A has a maximum capacity of 10,000 tires per month and an unlimited market demand at a price of $200 per tire. The speaker explains that in such a situation, Department A would likely set the transfer price for Department B at the market rate of $200, given that there is no constraint on selling the tires externally. The paragraph also discusses the minimum transfer price, which should cover at least the variable cost of production, and emphasizes the importance of market price as the most reasonable transfer price.

10:04

🔄 Scenarios Affecting Transfer Pricing Decisions

This paragraph explores different scenarios that influence transfer pricing decisions. It starts by considering a situation where there is no external demand for Department A's tires, leading to a minimum transfer price based on the variable cost of production. The speaker then presents a third scenario where there is an external demand of 6,000 tires and a current production level of 5,000 tires, which means Department A can sell an additional 1,000 tires externally. The paragraph discusses how the transfer price should be set considering the capacity utilization and the potential for external sales, as well as the implications of distribution costs and the potential savings when selling internally.

15:07

📈 Advanced Transfer Pricing Strategies and Conclusion

The final paragraph discusses advanced strategies for setting transfer prices, including the use of variable cost, full cost, market price, and negotiated prices. It also touches on the concept of contribution lost when internal sales replace external sales and how this should be factored into the transfer price. The speaker mentions different types of transfer pricing, such as cost plus, negotiated, and arbitrary transfer pricing, and advises viewers to read more on the subject for a comprehensive understanding. The paragraph concludes with a call to action for viewers to subscribe to the channel and engage with the content by leaving comments.

Keywords

💡Transfer Pricing

Transfer pricing is the method by which multinational corporations set the prices for goods and services sold between their own divisions. In the video, it is used to illustrate how internal company transactions, such as the sale of tires from Department A to Department B, are priced. The concept is central to the video's theme, as it discusses how transfer pricing can affect the autonomy and decision-making of different company departments.

💡Department A and Department B

These terms refer to two different divisions within the same company. In the script, Department A is responsible for manufacturing tires, while Department B assembles cars. The relationship between these departments is crucial for understanding the video's discussion on transfer pricing, as it shows how the pricing of inter-departmental goods can impact the company's overall operations and profitability.

💡Variable Cost

Variable cost is the cost that changes with the level of output, such as the cost of raw materials in manufacturing. In the video, the variable cost of manufacturing one tire for Department A is given as $100. This concept is integral to determining the transfer price, as it represents a baseline cost that must be covered for each tire produced.

💡Fixed Cost

Fixed cost is the cost that does not change with the level of output, such as rent or salaries. In the context of the video, the fixed cost for manufacturing one tire by Department A is $20. Understanding fixed costs is important for calculating the total cost of production, which is a key factor in setting transfer prices.

💡Market Price

Market price is the price at which goods or services are bought and sold in the marketplace. The video uses the market price of $200 for tires made by Department A as a reference point for setting transfer prices. It is a critical concept because it represents the external value of the product and can influence the internal pricing strategy.

💡Capacity

Capacity refers to the maximum amount of output that can be produced by a company or department. In the script, Department A has a capacity to make 10,000 tires in a month. The concept of capacity is essential in the video as it affects the availability of goods for both internal transfer and external sale, impacting the decision on transfer pricing.

💡Outside Demand

Outside demand is the market demand for a product from external customers, not associated with the company's internal operations. The video discusses scenarios where there is unlimited outside demand for the tires made by Department A. This concept is important because it affects the company's ability to sell products externally, which in turn influences the transfer price.

💡Autonomy

Autonomy in the context of the video refers to the freedom and independence that departments within a company have in making their own decisions, such as choosing suppliers or setting prices. The introduction of transfer pricing gives both Department A and Department B autonomy to decide whether to trade internally or seek better deals externally.

💡Contribution Margin

Contribution margin is the amount by which the selling price of a product exceeds its variable cost, indicating how much each unit contributes to covering fixed costs and profit. The video mentions a contribution margin of $100 per tire sold externally at a market price of $200, with a variable cost of $100. This concept is important for understanding the potential profit loss when internal transfers are prioritized over external sales.

💡Negotiated Transfer Pricing

Negotiated transfer pricing is a method where the transfer price is determined through discussions between the involved parties, aiming to reach a mutually agreeable price. In the video, this concept is used to describe a scenario where Department A and Department B negotiate a transfer price for tires, considering factors like cost, market price, and previous external purchases.

💡Arbitrary Transfer Pricing

Arbitrary transfer pricing is when the transfer price is set by top management without negotiation, often as a directive. The video mentions this concept as a fallback when negotiation between departments fails, illustrating an alternative approach to setting transfer prices within a company.

Highlights

Introduction to the concept of transfer pricing and its significance in commerce.

Explanation of transfer pricing through an example involving two departments within a company.

The problem of quality inconsistency in products transferred between company departments.

The impact of transfer pricing on departmental autonomy and decision-making.

How transfer pricing introduces competition within a company for better product quality and pricing.

The calculation of transfer price based on variable and fixed costs.

Importance of capacity and outside demand in determining transfer pricing.

Market price as a reference point for setting transfer prices.

Scenario analysis of transfer pricing when there is unlimited outside demand.

The minimum transfer price should be the variable cost in the absence of outside demand.

The best transfer price is often the market price for both department managers' satisfaction.

Consideration of distribution costs in the calculation of transfer prices.

The impact of lost contribution on transfer pricing when prioritizing internal over external sales.

Different types of transfer pricing methods used by companies.

Negotiated transfer pricing as a method to find a mutually agreeable price.

Arbitrary transfer pricing as a top-down approach when negotiations fail.

The importance of understanding transfer pricing for professional exams like CA, ACCA, CPA, CMA.

Encouragement for viewers to subscribe and engage with the channel for more informative content.

Transcripts

[Music]

hi i'm the commerce specialist welcome

to my channel in today's video we are

going to talk about transfer pricing

transfer pricing is relatively a new

concept but at the same time it's very

interesting

so what is transfer pricing i'm going to

explain you with the help of an example

you'll be able to understand it very

well let's assume a company has two

department department a

and department b

now this a and b are two departments of

the same company

and what the company does they make and

sell cars so we are assuming

department a

manufactures

tires

and then these tires are then

transferred to department b and then

they assemble the car

obviously they put the tires and then

the final car

is sold in the market

now the problem department

b is facing

is that the quality of tires made by

department a is not up to the mark

because of which they are having issues

selling the car in the recent past

what used to happen is department a

was

very careless

why because they knew

whether the quality of the tires they

are making is good or bad whether the

cost is high or low

they are indifferent because they know

ultimately the tires will go to b and

now it is their responsibility to

assemble to put the tires in the car and

sell it in the market whether they are

able to sell or not department a is not

concerned

but no more

with the introduction of transfer

pricing now it is possible for

department b to decide

whether they still want the tires made

by department a or they would like to

buy it from outside supplier which could

be more competitive or maybe higher

quality of tires may be at low price

but in the recent past b never had the

option to buy tires from outside the

only option they had is to get the tires

from department a

whether they supply on time whether it

is of high quality whether the cost of

production is high or low whatever

b had no option

but under transfer pricing what is

happening is

one of the main objective of companies

using transfer pricing is giving both

the departments the autonomy

the freedom to decide

so it works both ways

a

has the option

of

selling the tires they make

in the outside market if they're getting

a good price

they also have the option if they want

they can sell that our tires to b

for which b will obviously pay that is

known as the transfer price

and if you look at b b also has the

option now if the company uses transfer

pricing b also has the option either to

buy from outside or to purchase the

tires which is made by one of the

department which is part of the same

company

so now here we are looking at

how do we arrive at a transfer price

so i'm giving you some examples here

let's say

the variable cost of manufacturing one

tire

for department a is hundred dollars

the fixed cost for manufacturing one

tire by department a is 20

so the total cost of making one tire is

120.

so ideally if the total cost is 120 for

making one tire they are part of the

same company a should be selling one

tire for 120 to b

but as i said now a has the option of

selling it outside

so before we decide any transfer price

there are two important things we need

to look at number one

the capacity

for our example i am assuming the

capacity a can make maximum

10 000 tires

in a month

b

the second important thing

is the outside

demand the outside demand

what if i say

there is unlimited demand

there is unlimited demand for the tires

made by department a

and one important thing you need to look

at is what is the market price

market price

obviously we're talking about outside

market price

for tires made by department a let's say

it's 200

so given the scenario here

a has the maximum capacity a can make 10

000 tires in a month

all right

and can they sell the tires which a is

making can they sell it outside yes

the demand for tires made by a in the

outside market is unlimited means a can

make

all 10 000 tires

and can sell it easily outside in the

market for how much 200

now what we are assuming is

b needs

we need 1000 tires

1000 times from a

if i am the manager of department a

and b comes up with this request of 1000

tires

you know what i what is my thought

process

i can make 10 000 tires and i can sell

easily outside for 200 dollars each tire

b is asking me for 1000 which means now

i have to sell outside 9000 and 1000

tires i should be selling to b

so if outsiders are willing to pay me

200 for one tire i demand the same from

me

so please remember

the transfer price

in this situation where there exists an

unlimited outside demand

and where we have the capacity yes we

can make 10 000 tires

and b is only asking for one

but the issue is i can make 10 000 and

sell outside

so why should i sell b at a lower price

when i can get for all my tires at the

rate of 200 outside so the transfer

price in this scenario is i will ask

department b's manager okay i will

supply you 1000 tires but you pay me

what others are paying me

simple and straight

scenario 2

what if

there is no outside demand for the tires

made by a

department a can make 10 000 in a month

but nobody is willing to buy it outside

now if department b comes up with a

request of 1000 tires what to do

yes i would like to sell tires to b

and then

look at my cost

here i would like to tell you from

examination point of view

whether you are appearing in any

professional exam whether it be ca acc

cpa cma please remember one point

whenever you are asking the question

what is the minimum transfer price to

charge please remember the minimum

transfer price to charge is always the

variable cost

the minimum price to charge is the

variable cost

i'm not saying that we should always

charge the minimum price but if the

question asks you what is the minimum

price to charge it's always the variable

cost in this scenario i have no outside

demand my cost of production of one tire

is 120 if b is asking me ideally i

should be asking for 120 at least i want

to cover all my cost

but if the question says what is the

minimum price 8 should charge to be in

the absence of outside demand the

minimum price to charge will be the

variable cost which is 100 otherwise it

will be 120.

i hope you have understood this

another question is asked most of the

time what is the best transfer price

which keeps both the department managers

happy please remember the best transfer

price the most reasonable transfer price

is always the market price

please remember these are exam tips now

a third scenario could be

for example

outside demand

is

6 000 tires

and if i give you one additional

information

current

production level

is

50

means

the total capacity is 10 000.

at the moment

department a

is making fifty percent use of its

capacity which means they're making five

thousand tires

outside demand is 6000 that means they

can make one more 1000 tires and total 6

000 tires they can sell outside

that's okay

now if department b asks for 1000 tires

so if i'm department a's manager i need

to ask

what is my total capacity 10 000

how much i need to sell outside

my outside demand is 6 000 tires so

obviously outside demand means i can

sell it at 200.

so if i can make total 10 000 tires if i

can make 10 000 tires 6000 i can easily

sell outside

so if i'm making and selling 6000 tires

for example that's okay

now b is asking for one thousand dollars

my total capacity is ten i'm making and

selling six thousand outside can i make

one thousand more the answer is yes

so what price should i charge 200 no 200

is not a possibility because even b

knows that

that outside demand is only 6 000 for

our tires so i can make 6000 and sell

not more than 6000 if that was the

possibility i would love to sell outside

them

unless b offers me the same price

so in this scenario if i'm making and

selling 6000 tires outside i can make

1000 more tires and this 1000 more tires

either i asked b to pay me 120 no way

200

or if the minimum price that is hundred

so please keep this in mind

sometimes what happens

the question gives you in the similar

example uh

let's say one more point which is uh

distribution cost

per tire

which is let's say dollar two

for outside sales

so what is happening is

when i make tires yes my capacity is 10

i can easily sell 6000 outside but when

i do that i have to pay distribution

cost

because obviously tires are to be

delivered to the customer's place right

now if 1000 tires are required by

department b

that means

i'll be saving distribution cost of two

dollars

which

means this variable cost when i'm

talking about 100 this includes the

distribution cost

so what is the minimum price i should be

charging to department b if i choose to

give them 1000 tires the minimum price

would be the variable cost

minus the saving of distribution cost

which will be 98.

if it is not asked that the minimum cost

what should be the transfer price

normally at full cost full means

absorption cost absorption means

variable and fixed both so it is 120

minus 2

which is

180 so you have to look at if we are

transferring goods within the

organization it may save a certain cost

that should be subtracted

if you're selling outside there will be

some additional cost that should be

factored in

okay

one more important thing you need to

remember is sometimes what happens

that my outside

current production level is also 10 000

outside demand

is also 10 000

and there is no distribution cost

which means i'm making 10 000

my total capacity is 10 i'm making 10

i'm selling outside 10.

so now if department

b asked me for 1000 i need to consider

this

that in order to sell 1000 ties to b i

have to sell 9 000 over there if i sell

9 000 means i'm not selling 1000 there

if i'm not selling 1000 there there is a

contribution lost

so if you look at

contribution

contribution is the selling price minus

variable cost

my selling price is 200.

my variable cost is hundred so the

contribution

lost is hundred dollar per tire

which means

b is asking me for one

1000 tires so 100 into 1 thousand is

hundred thousand

this is my contribution lost

so if b is asking me

not to sell one thousand tires outside

but to transfer them provide them with

one thousand tires what will be my cost

so please have a look at this cost

100

per tire i am losing which definitely

which is contribution lost

contribution lost

per tire

definitely i'm going to charge b for

that

plus i'm going to charge my variable

cost

and if the question is not of minimum

price i would also like to charge my

fixed cost which is 20.

so this is the price i'll be asking b to

pay me

120 is my manufacturing cost

okay i'm not selling outside i'm losing

contribution of 100 per tire so you pay

me that you compensate me that

so please remember

if the question says that in order to

supply

an internal department you have to

compromise on outside sales so the

outside contribution lost is also to be

factored in when calculating cost of one

tire

guys another area of

transfer pricing is the types of

transfer pricing which a company can use

so let me tell you there are different

types there are many i'm just discussing

few

one is transfer pricing is also possible

at variable cost which is the minimum

price

i can transfer means it can transfer to

b only at variable cost a can transfer

to b at variable cost plus fixed cost

which is known as full cost or

absorption cost

a can also transfer to b

at full cost plus some profit we call it

cost plus

a can transfer to b tires at market

price

it can transfer to b

at a transfer price which is negotiated

negotiated means for example

my cost is 120 what if i know that b was

buying tires earlier from outside for

180

so if v has already been buying for 180

why can't you give me 180 and if not 180

at least somewhere between 120 and 180

if you want to buy from me

what if outside a price if b has been

buying the market price outside for

tires 200 so i know that okay i don't

have outside demand but if you buy from

outside it is for 200 so why don't you

pay me 200. we said no you are the same

department so what we do we set me and

department b's manager will sit down we

negotiate and we negotiate a price

somewhere between 120 and 200.

it depends who's the better negotiation

negotiator i would like a price which is

very close to 200 and we would like a

price which is very close close to 120.

that is known as negotiated transfer

pricing

the other transfer pricing is known as

arbitrary transfer pricing what if the

negotiation fails then the top

management instructs me

please transfer tires to be at this

amount that's it

end of the discussion

there are many other transfer pricing as

i said there are dual rate and there are

multiple transfer pricing so

you can go into the details read the

books i hope i've explained some key

points to you if you have any other

questions relating to transfer pricing

please leave a comment i will respond to

you as usual if you like this video

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[Music]

you