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Transfer Price = Variable cost/unit + Lost contribution margin/unit
We assume a partially decentralized MNF, so the headquarters determines the transfer price and the downstream branch determines the level of the final output.
Some companies have experienced the pain of not getting their transfer prices right in the eyes of the IRS.
The manufacturing segment is the sole source of supply for the distribution segment and sets the transfer price for the goods ordered by the distribution segment.
Companies can determine a market-based transfer price by comparing current prices if the business unit also sells to the market.
The resale price method was used, and the APA was based on an outbound transfer price (see Exhibit 2 for a glossary of terms).
However, because the arm's length principle cannot always be applied with full precision, it leaves some room for reasonable interpretation; and companies will use that room to structure their transactions and transfer prices to enhance the bottom-line and shareholder value while still complying with tax rules.
Assume that Sigma's policy is to set prices by applying a markup of 30% over variable cost; thus, it sets the transfer price at $13 ($10 x 130%).
To assist the subsidiary in B to make an appropriate quantity decision, the MNE uses a transfer price on the good shipped from A to B.
Because transfer prices can play a role in determining the distribution of income among the members of a controlled multinational group, transfer pricing also affects the tax provision of a multinational through its effect on unrepatriated earnings.
A second issue is the selection of a transfer price, a process complicated by decentralized organizations that grant managers the right to set prices, which in turn affects their performance evaluations and rewards.
The guidelines apply the "arm's length" principle mandated by the OECD, which stipulates that a transfer price should be the same as if the corporate entities involved were independent and not part of the same corporate structure.