Useful Notes on Transfer Pricing ( With Examples)

Recently, fierce competition among big business houses has compelled them to offer more and more differentiated products.

Once a firm markets its differentiated product, other competing firms also bring out a similar or better product so as to make perceived benefit deriving out of their product and the first mover’s product at least equal. Race on product differentiation gradually reduces quality differential and erodes differentiation advantage. Thus, apart from focusing on product differentiation, firms also try to
explore the other avenues like cost reduction or aggressive marketing to ensure competitive advantage. Cost reduction not only helps to win competitors, but also expands customer base, which raises total profit.

One of the ways to reduce cost is outsourcing activities (partially or completely) of a firm to firms located in Low Cost Countries (LCCs) like China, India etc., where cost differential arises mainly out of low labour cost. Generally, components are manufactured in LCCs and value added (further processed) by the Parent company located in High Cost Country (HCC). Transfer pricing is defined as “the price charged for a trans-border transfer of goods, assets, money, rights, services between one part of an organization to another part of the same organization.”

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The question is, at what price the parent firm will pay to the entity located at the LCC for procuring the components. This question apparently seems to be very innocent, but determination of the price acceptable by both the governments is extremely difficult. The reason being, the price at which goods are transferred from a LCC to a HCC affects revenue of the governments of both the countries.

For obvious reasons, the government of the LCC will not accept any transfer price less than the price which is generally charged by independent third parties in same or similar transactions. On the contrary, the government of the HCC will be happy if firms located at HCC can procure goods at a lower price than that of the comparable transactions from entities located at LCC.

Therefore, importance of TP lies in the problem of determination of appropriate transfer price for inter-company transfer of goods, since these are not traded in the open market and consequently market price is not available.

First, we will explore the economics behind determination of optimal transfer price and then enumerate the method being followed in practice.

For the purpose of determination of optimal transfer price, we consider two possibilities:

(i) A situation where the component manufacturer is the only supplier of that kind, and

(ii) A situation where perfect competition exists in the component market.

Case I:

In case of the first possibility, the final product (say, P) is manufactured by the Parent Company (say, XYZ) located at the HCC. For each unit of product P, one unit of its component, say X, is outsourced from a subsidiary (ABC) of the parent company XYZ. The subsidiary ABC is located at a LCC.

It is interesting to note that price of the component is not available, since it is not sold in the open market. Suppose, demand for the final product P is D_p. The marginal revenue of P derived from D_p is MR_p. Assume that production process of the final product P consists of two steps – Step I involves conversion of raw materials to component X (denoted by C_x) and Step II refers to that stage of conversion where component X is used to produce the final product P (denoted by C_n). The marginal cost of producing component X is MC_X and marginal cost of Step II in isolation is MC_n , so that MC„ and MC_X constitute marginal cost of the end product P, i.e., MC_p.

Price of the end product is determined as P,, which is obtained from fulfilling the f.o.c., i.e., equality between MC_p and MR_p (see Figure 14.4). Profit maximizing quantity of final product P is obtained as Q_r Since Q₁ quantity of the final product P will be produced by the parent firm and each unit of the end product requires only one component X, Q, quantity of X will be produced and transferred to the parent company for production of the final product. The MC of component X at Q, output level is P₂. Thus, the transfer price of the component X is P₂.

Case II:

The previous case remains unchanged here excepting the assumption that perfect competition exists in the component market. The implication of the assumption is that large number of sellers is selling the product (component) in the LCC at a fixed price.

There can be two variations of this possibility. Let us explore these possibilities one by one. Since all other conditions remain the same regarding the end product, price of the end product i.e., P_l7 also remains the same (see Figure 14.5).

But since perfect competition exists in the component market located at LCC, the price of that component is fixed irrespective of output level. Assume P₃ is the market price per unit for ABC (i.e., P₃ = MR_X). So, P₃ is also the MR of ABC. Thus, the profit of the affiliate / subsidiary of XYZ is maximized where MR_X = MC_X. MR_X and MC_X intersect at point e, which helps in determining the profit-maximising quantity, i.e, Q₃. Since Q^Qj, the subsidiary will supply OQ₁ output to the Parent and Q_tQ₃ can be sold in the open market.

The other possibility (Figure 14.6) shows that P₄ is too low and consequently, profit-maximising output of subsidiary falls short of OQ_r As a result, OQ₄ quantity should be procured from the subsidiary unit, while the rest, i.e., Q₄Q, may be purchased from the market.