 Hello and welcome to this session. This is Professor Farhad and this session we would look at transfer pricing methods. This topic is covered in international accounting or taxation course as well on the CPA and ACCA exam. As always, I would like to remind you to connect with me only then if you haven't done so. YouTube is where I house my 1500 plus accounting, auditing, tax and finance lectures. This is a list of all the courses that I covered, including CPA material. On my website, farhadlectures.com, you can find additional information such as notes, PowerPoint slides, multiple choice through false questions, exercises, which are quasi CPA simulations and 2000 plus CPA questions. Please check it out. So let's talk about transfer pricing methods. So you have to understand the method that we set transfer for international transaction is the same as local transaction or the same as domestic context. And this includes cost-based transfer price, market-based transfer price and negotiated price. So if you know anything about my lectures, once I have a list, I'm going to go over each item in this list separately, starting with the cost-based transfer price. And as the word suggests, it's cost-based. Well, what do we do if it's a cost-based? What's going to happen? The first thing we're going to do is we're going to assume there's no external market. Simply put, the intermediate product that we are selling between our subsidiaries or from the subsidiaries to the parent or from the parent of the subsidiaries has no external outside market. And it has to be processed further until it's finished goods. Once it's finished goods, it's supposed to have to have a market price. So this is the assumption when we use the cost. So the transfer price is based on the cost to produce the service. So it's cost plus markup, obviously, but you start with cost. Now, the question is, how do you determine the cost? Now, I'm sure you took a managerial accounting course and you took a cost accounting course. And remember, you can compute the cost in different ways. You could use variable production only, which is variable cost. You could use variable plus a part of the fixed cost plus fixed cost production cost. Or you could use full cost, which is either based on actual or budgeted amount, which is the standard amount or the actual amount. So those are the three costing system. And that's depending on which method you use. It's going to determine the final price. Okay. And we're going to see what are the pitfalls and advantages for each method. So remember, the transfer price include a profit. So in addition to the cost, you notice you include some sort of a markup or a cost plus to come up with that price. So it's not like only cost. Okay. So cost-based system, they're easy to use because you just have to determine the cost. But the question is, which cost are you measure? Which cost did you use? Now, what is the problem to be more specific? What happened sometime? The inefficiencies in one unit may be transferred to other units. What does that mean? If I'm saying, I'm going to sell you my product based on cost. Well, what does that mean? Well, it means whatever it's going to cost me, I'm going to transfer it to you. Well, that's going to give me no incentive to control my cost because you are going to pay me the cost. So that's why there's no incentive to control the cost. So you have to do, to be more efficient, you have to use a standard rather than actual cost. So you use the standard. What does it mean standard? Standard means this is how much it should have cost you to produce this product versus actual. Actual is this is what it actually costs you. What does that mean? It means let's assume you are producing a unit, whatever that unit is, you are making a pizza, okay? Just to make it simple. For the pizza, you need sauce, cheese and dough. And those three things, sauce, sauces, cheeses and doughs, they should cost based on your costing system, they should cost $3. Now, what happened is when you produce that pizza, it costs you $4 because you might have lost some cheese, you had to replace the dough. Whatever the reason is that the actual was higher. Well, guess what? I'm going to assume, I'm going to, I'm going to assume your cost is three. You cannot assume your cost is four because it should have cost you $3. And this is called standard costing. Again, if you took miniaturial accounting or cost accounting, but I'm going to have to assume and you should know the difference between standard and actual cost if you are looking at transfer pricing. So that's why standard cost would alleviate this problem. The second method is market-based price. And the market-based price is, as the word suggests, is market-based. Simply put, I'm going to pay you what you are offering me, the equal value. Here we assume that there is a value. There is an external competitive market because if there's no external competitive market, how do we know what the value is? So here we are assuming there is an external market. And this method is consistent with the responsibility accounting and the philosophy of decentralization. Decentralization, this is misspelled, decentralization. Okay. So market-based system avoid transferring inefficiencies of one division or subsidiaries to another, which is a problem associated with cost. And a market-based, guess what? I'm going to sell you the product based on what you can buy it from somewhere else. Therefore, I'm not transferring my extra cost to you because the market is efficient. The market determines the price, not my cost, not what I actually incurred. Okay. And this way you would help ensure divisional autonomy. This way you are really working with the decentralization is being used properly and this way you can evaluate the subsidiaries performance, which is the topic that we're going to be discussing next, not in the session and the next session. It's the incentive. It gives you a good incentive to be efficient. Okay. So the efficient working of market-based system depend on the existence of a competitive market and dependable market quotations. So simply put what you are saying, if you can go out to the market, you can ask a third party supplier and they can give you the price. Now, for certain items such as unfinished goods, okay, which is intermediate goods, there may not be any buyers outside the organization and there's no external market. And that's the problem with the market, with the market-based is you are producing something. It's not a final product. It's a product that, for example, you are producing a unit that you don't sell independently and no one sells independently, but it goes into another product and that product is sold independently. So how do you know what that unit is? What's the price for that unit? So that's the problem with market-based transfer pricing. Negotiated price, as the word suggests, you know, two people negotiating the price. This is how it works. What happened here is you would say, my market price is the starting point and my cost is the lower boundary, lower boundary. What does that mean? It means here we go. If we say this is the market price, so you start to negotiate and this is the market price, the highest and the cost here. So you'll try to figure out a price in between, okay, because you cannot be above the market because the person goes to the market and you cannot be below your cost because, you know, then you are losing. So it's someplace in between the market and the cost. Now here it allows subsidiaries managers to bargain with one another with freedom and assuming the parent company gives them that freedom. Okay, it's important. There are external market as well because you need to determine what's the external market because that's your starting point to have objective information for negotiation. Now, what are the pitfalls for negotiated prices? One is time-consuming. Time-consuming means it's going to be a lot of back and forth and sometimes egos play a role where, you know, I'm going to be, you know, I don't want the other manager to, I want them to lower the price. Then personal issues would get involved. Also, another pitfall of this is well, what's going to win? The person with better negotiation ability rather than the economic cost and reality and that may not be efficient for the overall company. So those are the pitfalls for negotiated price. Now the parent company can intervene to kind of speed up the process or make sure everything is fair, but that defeat the concept of the centralization. So if you want to summarize all three methods, okay? So management accounting theory suggests that different pricing methods are appropriate in different situation. If you have a market-based product, well, that's good. That's the best, okay? So you have a market for the product and there's perfectly competitive market, which is you can have the price and there is interdependency between the related parties are minimal. So basically if I can go somewhere else, if I don't like, if I don't like your price, okay? Otherwise if I can go somewhere else, then market price is not efficient and there's no advantage of disadvantage of buying and selling the product internally rather than externally. So whether I sell it to you or to somewhere else, it's the same thing. So in theory, market price is the best as long as you have a perfectly competitive market and I can either sell it to the outside or to the inside external or internal parties at the same price. Market price based on full costing can approximate market price when the determination of the market price is not feasible. So when do you use full cost or costing is when you cannot find the market price. So what do you do? You restore to cost. You go with cost plus 10% or cost plus 15%, okay? Negotiated price, okay, by buyer and seller rather than this is a good method because it's not being pushed from the above, okay? It gives you the advantage of allowing related parties to maintain the decentralized authority. So negotiated price is perfect for companies. They want to maintain, they want to encourage decentralized authority. Now in the previous session, I talked about decentralization and why is that important? The advantages and disadvantages of decentralization. In the next session, I would look at the objective of international transfer pricing, which is we looked at it very briefly in part one, which is performance evaluation. In the following session, I would look also at the objective but from a cost minimization process. As always, I would like to remind you to visit my website where I have more resources than just lectures for all these courses. And I suggest you invest, subscribe. It's minimal and it's a great investment in your career. Study hard and stay motivated.