How Is Minimum Transfer Price Calculated?

A company that transfers goods between multiple divisions needs to establish a transfer price so that each division can track its own efficiency. Companies will use various methods to determine the minimum transfer price, factoring in different costs related to production and what the goods would normally sell for in the retail marketplace.

Corporations with operations in various countries may attempt to shift the transfer price to divisions located in countries with lower tax rates, thereby reducing their corporate tax obligation. While this practice can result in greater profits for multinational corporations, it can also lead to greater scrutiny and regulation from tax authorities like the Internal Revenue Service (IRS).

Key Takeaways

• A transfer price refers to the price that one division of a company charges another division of the same company for a good or service.
• A company may calculate the minimum acceptable transfer price as equal to the variable costs or equal to the variable costs plus a calculated opportunity cost.
• Most companies will set the minimum transfer price at greater than or equal to the marginal cost of the selling division.
• Some multinational corporations will attempt to manipulate the transfer costs between divisions in order to reduce the amount they pay in taxes, a practice that happens more often when one division is located in a country with significantly lower corporate taxes.

How to Find the Minimum Transfer Price

There are different ways to find the minimum acceptable transfer price. Some companies simply set the minimum as equal to variable costs. Others add variable costs with a calculated opportunity cost. The general economic transfer price rule is that the minimum must be greater than or equal to the marginal cost of the selling division.

In economics and business management, a marginal cost is equal to the total new expense incurred from the creation of one additional unit. For example, suppose a hammer manufacturing company has two divisions: a handle division and a hammer head division. The hammer head division only begins work after receiving handles from the handle division. This means the handle division is the selling division and the hammer head division is the buyer.

If it costs the handle division $7 to fashion its next handle (its marginal cost of production) and ship it off, it doesn’t make sense for the transfer price to be $5 (or any other amount less than $7). Otherwise, the handle division would lose money at the expense of money gained by the hammer head division.

Factoring in Opportunity Costs

Suppose that the hammer company also sells replacement handles for its products. In this scenario, it sells some handles through retail sales rather than sending them to the hammer head division. Suppose again that the handle division can realize a $3 profit margin on its sold handles.

Now the cost of selling a handle isn’t just the $7 marginal cost of production, but also the $3 in lost profit (opportunity cost) from not selling the handle directly to consumers. This means the new minimum transfer price must be $10 ($3 + $7).

Minimum Transfer Price and Tax Regulations

For accounting purposes, large corporations will evaluate their divisions separately for profit and loss. When these different divisions conduct business with one another, the minimum transfer price for a particular good will usually be close to the prevailing market rate for that good. That means that the division selling a good to another division will charge an amount equal to what they could achieve by selling to retail customers.

However, in some instances, companies will attempt to increase or decrease the transfer costs between divisions in order to lower the amount they pay in taxes. This deliberate manipulation of costs is more likely to occur when the divisions are located in different countries where one country is a tax haven and has a much lower tax rate than the other.

Obviously, the tax authorities in countries with higher tax rates frown upon this practice as it means lost revenue for them. Thus, these countries have strict regulations to prevent companies from using transfer pricing as a tax avoidance strategy.

Regulators look at the company’s financial statements to ensure their transfer pricing is in line with current market pricing. In general, these regulations attempt to ensure companies abide by arm’s length practices, which prevents collusion between divisions within the company to misstate transfer prices.

Read the original article on Investopedia.