Transfer Pricing and Activity Based Costing:

Activity based costing (ABC) is based simply on the premise that businesses must understand the factors that change each major activity and the costs of these activities, and how different activities add values to the firm related to the products in order to run the business effectively and efficiently. The role of transfer pricing policy is to allocate costs within the firm to determine the optimal product mix. The activity based costing approach justifies the transfer prices a multinational corporation uses to transfer unique company services among its divisions located in different countries. This article is an attempt to explain how this approach reduces the probability of costly tax audits and assists in obtaining an advanced pricing agreement. Moreover, this article contrasts the traditional and ABC approaches and shows how the approaches can significantly affect transfer pricing tax liability. Nevertheless, this article provides a glimpse of the potential of ABC in the development of an effective transfer pricing mechanism, one that lowers the risk of a transfer price audit and gives the multinational enterprise (MNE) the flexibility to adjust costs to compete successfully in the global market.