- Email: [email protected]
An alternative to transfer pricing
An Alternative to Transfer Pricing The author proposes a pricing scheme that combines the advantages of cost, market, and negotiation transfer pricing without the disadvantages of those conventional pricing methods.
PETER MAILANDT
Peter Mailandt is an associate o f McKinsey & Company, Inc.
A decentralized corporate organization is c o m m o n l y recognized as the most effective structure to serve the needs of large multiproduct, multiservice companies. The subdivision of a corporation into separate, largely autonomous profit and cost centers accomplishes many purposes. TWO of the most important ones are: To stratify the wide spectrum of markets served, products manufactured, and services offered into segments, each one of which is reasonably transparent when (1) evaluating markets, products, processes, and services; (2) identifying, isolatinz, and solving problems; and (3) locating and exploiting opportunities. To provide a proving ground for managers who, to various degrees, are free to exercise authority over sources of input, level of output, application of people and capital resources, and financial and long-range planning.
Establishing separate profit centers means setting up distinct accounting entities to control and to evaluate the profit centers' internal operations in accordance with the company's overall goals and objectives. The existence of two or more profit centers or autonomous divisions frequently gives rise to controversies among operational units. The two main areas of interdivisional friction are readily identified as the allocation of corporate and joint cost among benefiting
OCTOBER 1975
divisions, and the establishment of intracompany transfer prices. This article deals with the problem of intracompany transfer pricing. The need for transfer prices has been recognized by virtually all large companies. As Joel Dean observed twenty years ~ o , trying to operate without transfer prices would severely jeopardize effective decentralization and would avoid no problems. 1 In this article, I will propose a new approach to transfer pricing that promises to overcome m a n y of the problems and controversies associated with conventional transfer pricing methods. (To aid the reader, a list of terms used in this article and their definitions is provided in the accompanying "box.")
PURPOSE OF TRANSFER PRICING Divisions of highly integrated companies typically engage in lively trade with one another, and the effect of transfer prices can be seen in most facets of operations and planning. Decisions at division level as to what products to 1. National Industrial Conference Board, Interdivisional Transfer Pricing, Business Policy Study No. 122 (New York: National Industrial Conference Board, 1967). Joel Dean, "Decentralization and Intracompany Pricing," Harvard Business Review (July-August 1955).
81
PETER MAILANDT
The following is a list of definitions of terms used in this article.
82
Product includes services, c o m p o n e n t s , subassembflies as well as finished goods. Division is a profit or cost center that is a u t o n o m o u s within a c o m p a n y with respect to procuring input products from internal or external sources. Transfer price refers to the price at which a product unit is transferred from one division to another. Total cost is the sum of all direct, indirect, and allocated cost and expenses incurred by and allocated to the division. In effect, the concept presented calls for identical cost allocation for products sold within and outside the c o m p a n y . Division profit margin is the ratio of pretax profit to sales realized by the division. Product profit margin is the profit margin the selling division w o u l d realize if it were to sell its product in a competitive, uncontrolled outside market. If no applicable outside market can be identified, a substitute " p r o d u c t profit margin" can be established, as outlined in the text. Cost markup is the supplying division's percent markup from total cost to arrive at the transfer price. Market price discount is the percent rebate from the market price at which the p r o d u c t is transferred to the purchasing division. Margin distribution index is the relative distribution of the p r o d u c t profit margin between the selling division and the buying division.
The following example illustrates the terms defined: The total cost of a product to the supplying division is assumed to be $8.40. The comparable market price is $12.00 so that the product profit margin is $3.60 or 30 percent. If the margin distribution index is set at 2, for every two dollars of profit made by the supplying division the buying division will be allowed a one-dollar discount from the market place. The transfer price is therefore set at $10.80, the cost markup is $2.40 or 28.6 percent, and the market discount is $1.20 or 10 percent. The supplying division profit margin is 22.2 percent.
manufacture at what quantities frequently depend on the profitability of "individual products relative to each other. Production of goods whose costs are expected to rise is favored by transfers at cost-plus; products with good cost reduction potential are promoted when transfer prices are tied to the market. Transfer price-dependent profitability considerations will influence make-or-buy, and may influence capital expenditure decisions at the division level, but this influence may not bring about sensible performance improvement programs at the division level unless an adequate incentive is provided for the burdened profit center. Sound transfer pricing practice should allocate profits among the participating divisions so that the profits are permitted to settle where the m o n e y has been earned. This serves two purposes; first, potentially unprofitable business units can be identified and top-level attention focused on the problem areas. Second, an objective appraisal of division performance can be complemented by an objective appraisal of the manager's performance. Although participants readily agree that sound transfer pricing policy is a key to effective business decisions, two divisions trying to protect their own interests in their interactions often find the individual requirements on transfer prices to be contradictory. The transfer price is forced into the role of being a servant for two masters. How can the need for fair financial representation of intracompany transactions be satisfied without compromising the need for effective control and for providing incentives for performance inprovement in the participating organizations? Little hope can be held for a cost or cost-plus pricing scheme that disregards market value. Nor can there be much hope for a market-value-related transfer price that rejects cost considerations. Market- and cost-oriented
BUSINESS HORIZONS
An Alternative to Transfer Pn'cing
views both must enter into developing sound intracompany transfer prices. When this is done, a relatively simple pricing scheme such as the one I am proposing can accommodate the competing interests of the interacting division as well as comply with the control and performance incentive objectives of the total enterprise.
A NEW APPROACH
The new concept is basically simple. Once a year a transfer price is agreed upon by the interacting divisions through negotiation. The negotiation, in effect, focuses on allocating the margin between the supplying division and the buying division by setting the transfer price at a level above total cost but below market price. The transfer price relative to the total cost incurred by the supplying division and relative to the comparable market price will yield the cost markup and the market price discount, respectively.. If one starts with the cost markup and the market price discount, calculation of the "product margin distribution index" is as follows: Equation A Product Margin Distribution Index = Cost Markup % (lO0--Market Discount %) Market Discount % (100 + Cost Markup %)
In the proposed method, the distribution index for the product margin is held constant throughout a designated future period. Changes in the product margin due to changes in the costs incurred by the supplying division or due to changes in the comparable market price will affect the transfer price. However, the index that characterizes the distribution of the product margin between the interacting divisions will not be allowed to change. This "automatic" adjustment of the transfer price to account for changes in cost or market price
OCTOBER 1975
is the central feature of this intracompany transfer pricing method. Other aspects will be highlighted below. The lower and the upper limits of a transfer price are, respectively, the total cost to the supplying division and th'e comparable market price of the product. The total cost associated directly and indirectly with the product is usually well known since alternative transfer price methods based on cost, as well as an effective cost control system, are dependent on accurate cost information. Establishing a comparable market price is less objective and, therefore, more difficult in instances where published or other market price data are unavailable. One of the following methods is then suggested: 1. Identify a product within the company's portfolio for which total cost and market price are available and which relates well with the product under consideration in terms of markets served, product and process technology used, and unit/dollar volume sold. The profit margin of the identified product can be substituted for the profit margin of the product under consideration. 2. If no related product can be identified, the division's overall profit margin on outside business can be taken as the profit margin of the product under consideration.
With the total profit margin established, either directly or indirectly, the task remains to decide the margin distribution index. In his article on intracompany pricing, Joel Dean offers strong arguments in favor of determining transfer prices by negotiation where all parties are fully informed, are knowledgeable, and are free to deal with the outside. The margin distribution index is then calculated from the agreed transfer price. 2 Why should the transfer price be more than cost? To provide for a profit to the supplying division and with it a performance measure. Why should the transfer price be less than market price? To provide the buying 2. Joel Dean, "Decentralization and Intracompany Pricing," p. 2.
83
PETER MAILANDT
Effects of Changes in Cost and Market Price
List or market price ($) Transfer price ($) Total cost ($) Cost markup factor Market price discount factor Margin distribution index
Product profit margin Supplying division profit margin Market price discount Change in overall margin from from column 1 Change in supplying division margin from column 1 Change in market discount from column 1
84
Bench Mark 1
2
3
10.00 9.00 7.00
10.00 8.67 6.00
12.00 10.33 7.00
10.00 9.33 8.00
9.00 8.33 7.00
12.00 10.80 8.40
.286 .100
.476 .133
.477 .139
. 167 .067
.190 .074
.286 .100
2.0
2.0
2.0
2.0
2.0
2.0
30.0% 22.2% 10.0%
40.0% 30.8% 13.3%
41.7% 32.3% 13.9%
20.0% 14.3% 6.7%
22.2% 16.0% 7.4%
30.0% 22.2% 10.0%
+33.3%
+39.0%
-33.3%
26.0%
0.0%
+38.7%
+45.5%
--35.6%
-27.9%
0.0%
+33.3%
+39.0%
-33.3%
26.0%
0.0%
division with the financial incentive to purchase inside and thus contribute to a volumerelated reduction of cost per unit. Savings are also realized by the buyer in the form of reduced purchasing activity, reduced receivables, and reduced inventory risk-all commonly associated with intracompany purchases. In the annual negotiation of the index, all contributing factors must be weighed carefully, so that the index will not be subject to change.
HOW IT WORKS
To illustrate the proposed pricing concept and its positive features, some of which are not shared by other frequently used transfer pricing schemes, a numerical example is given in the accompanying table. It shows the impact of changing costs and shifting market prices on the transfer price. At the time of the annual transfer price negotiation, the total cost of a particular product is $7.00, and the comparable open market price is $10.00. Negotiations resulted in a margin distribution index of 2, indicating that for every margin of two dollars to the supplying division, the transfer price is one
4
5
-
6
dollar less than the market price. Accordingly, the first column in the table shows a transfer price of $9.00. Also shown are: the product profit margin, 30%; the supplying division profit margin, 22.2%; and the market price discount to the buying division, 10 %. Each subsequent column in the table shows the effect of changing cost or price levels on the transfer price, the cost markup and margin claimed by the supplier, and the market discount taken by the buyer. A decrease in cost by one dollar (column 2) lowers the transfer price by $.33 to $8.67. The margin for the supplier and the discount to the buyer increase by 38.7% and 33.3%, respectively, with respect to column 1 data. A rise in market price without a change in cost level (column 3) increases the transfer price so that both divisions expand their margins. An increase of cost without a market price move (column 4) penalizes the supplier more than the buyer. Column 5 represents a situation where a rise of cost is accompanied by a decline in market price, causing margin deterioration for both participants. A 20% rise in cost coupled with a market price increase by a like percentage (column 6) raises the transfer price symmetrically, preserving margin and discount percentages.
BUSINESS HORIZONS
An Alternative to Transfer Pricing
MAJOR A D V A N T A G ES The quality and usefulness of any intracompany pricing m e t h o d can be measured by how well it satisfies each of the following four requirements. 1. Transfer pricing must be easy to manage and to administer. The proposed method calls for negotiation, say, once a year to set the margin distribution index for the subsequent twelve months. The negotiation may or may not be time-consuming depending on the complexity of the business and the people involved. After the index has been agreed upon, the impact on the transfer price of any changes in cost or market price level can be readily calculated by the administrative staff without management involvement. Updates of the transfer price can be made according to a fixed timetable or whenever changes warrant revisions. 2. The transfer price method must provide a way to measure a division performance. The proposed transfer pricing method permits divisions to retain a share of the financial benefits derived from effective cost reduction efforts. Inversely, poor cost control is reflected in decreasing margins if the cost increases cannot be passed on to the market. Consequently, division-level profits in relation to sales are good indicators of the division's operational performance and the manager's contributions to the company's overall profit objectives. 3. Transfer pricing must promote continuous performance improvement. The proposed method rewards effective cost control, successful product or process improvement, and skillful marketing efforts by increasing the profit margin at the organizational level where improvements are implemented. 4. Transfer pricing must be fair to all participants and flexible in times o f change. The proposed pricing method permits adjustment of the transfer price to equal total cost ( i n d e x = 0 ) or to approach the market price (index is very large) and can thus accomodate all interdivisional preferences, corporate guidelines, or regulations of government agencies, without changing the concept or superimposing other pricing methods on the proposed one. Since inter/zUvisional pricing changes are relatively easy administrative tasks--the margin distribution index remains u n c h a n g e d - m a r k e t price changes can be accommodated quickly and fairly with minimum disruption and without a departure from the previously'agreed upon guidelines.
"A popular argument is that a policy of transfer price bargaining is a timeconsuming, never-ending process. However, the proposed method calls for negotiations only once a year or even less frequently, since changes in cost or market prices can be accommodated administratively and do not require new bargaining." ways to measure business performance. Control of cost has to be c o m p l e m e n t e d with control over price to an extent that is acceptable to the trading partners. Only then do financial results of operations fairly reflect managerial skill as well as the division's and the product's contributions to overall corporate success or failure. Developing and promoting skills of negotiation at the division level can only enhance the competitive position of a company in the marketplace. Not surprisingly, opposition to armslength price bargaining is most often voiced by managers who fear exposure of inadequacies in the area of negotiation. A popular argument is that a policy of transfer price bargaining is a time-consuming, neverending process. However, the proposed method calls for negotiations only once a year or even less frequently, since changes in cost or market prices can be a c c o m m o d a t e d administratively and do not require new bargaining. The arms-length negotiations do require the participants' full knowledge of the total cost to the supplying division as well as the competitive market price of a like product. The bargaining could focus on establishing a transfer price, which would in turn permit calculation of the margin distribution index: Equation B Margin Distribution Index =
IMPLEMENTING THE CONCEPT The "arms-length" negotiation of interdivisional transfer prices assures independence of operating entities and leads to m e a n i n ~ u l
OCTOBER 1975
Transfer Price-Total Cost Market Price--Transfer Price
Or the negotiations could lead to an agreement as to how the margin should be divided between the trading divisions. For example, the accord may call for t w e n t y cents to the
85
PETER MAILANDT
supplying division for every dollar to the buying division, fixing the margin distribution index at .2~ The resulting transfer price would then be: Equation C Transfer Price = M g g i n Distribution Index X Market Price + Total Cost 1 + Margin Distribution Index
86
This formula would also be used when events subsequent to the agreement on the m a r ~ n index change the total cost or the market price, calling for corresponding recalculation of the transfer price. The equations in this section and the numerical example show that the transfer price follows movement of cost as well as market price changes in a compensating manner. On the one hand, manufacturing cost increases cannot be passed on in total to the next division as in the cost or cost-plus transfer price method. On the other hand, effects of market price changes will be shared by all participating divisions. The far-reaching consequence of this is that divisions at all formation stages will become rightfully concerned about the structure and dynamics of
O0 ........
cost components and the market environment of the products with which the divisions are involved. illlllllll~l"ll'lll'l The proposed transfer pricing method, which distributes the available product margin between the exchanging divisions, o f f e r s - a t the cost of only slightly increased c o m p l e x i t y - a number of operational as well as planning advantages. Operationally, the financial statements of divisions enga~ng in considerable in-house trading are heavily influenced by the transfer price policy guidelines. The proposed m e t h o d permits top management to rely on financial statements as bases for performance appraisals to a larger extent than would be warranted with the conventional transfer pricing methods. Also, comprehensive planning and forecasting processes in divisions should involve reviews of cost as well as price structure of products and services. The constant margin distribution index transfer pricing m e t h o d requires the incorporation of cost as well as price considerations in business projections. This expanded planning scope should lead to an increased awareness of the company's overall profitability and competitive position by managers at all levels.
,~,00, = = = ,O0000000000000000000CO00000QOOOOOOOOOOOOOOOOOOOOOOOOOOOOmc'~mn
There are never absolute guarantees of security. One cannot properly judge a program by asking, "Is it guaranteed to w o r k ? " A more useful criterion is the standard implied in such questions as: " U n d e r what likely circumstances are the program's results useful enough to justify its various c o s t s and dis-utilities?" - S t e p h e n Enke, ed.
Defense Management O000C~--
• • , ~ o 0 0 r ~
.....
~
. . . . . . . .
O 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 u u O 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
BUSINESS HORIZONS
PETER MAILANDT
Peter Mailandt is an associate o f McKinsey & Company, Inc.
A decentralized corporate organization is c o m m o n l y recognized as the most effective structure to serve the needs of large multiproduct, multiservice companies. The subdivision of a corporation into separate, largely autonomous profit and cost centers accomplishes many purposes. TWO of the most important ones are: To stratify the wide spectrum of markets served, products manufactured, and services offered into segments, each one of which is reasonably transparent when (1) evaluating markets, products, processes, and services; (2) identifying, isolatinz, and solving problems; and (3) locating and exploiting opportunities. To provide a proving ground for managers who, to various degrees, are free to exercise authority over sources of input, level of output, application of people and capital resources, and financial and long-range planning.
Establishing separate profit centers means setting up distinct accounting entities to control and to evaluate the profit centers' internal operations in accordance with the company's overall goals and objectives. The existence of two or more profit centers or autonomous divisions frequently gives rise to controversies among operational units. The two main areas of interdivisional friction are readily identified as the allocation of corporate and joint cost among benefiting
OCTOBER 1975
divisions, and the establishment of intracompany transfer prices. This article deals with the problem of intracompany transfer pricing. The need for transfer prices has been recognized by virtually all large companies. As Joel Dean observed twenty years ~ o , trying to operate without transfer prices would severely jeopardize effective decentralization and would avoid no problems. 1 In this article, I will propose a new approach to transfer pricing that promises to overcome m a n y of the problems and controversies associated with conventional transfer pricing methods. (To aid the reader, a list of terms used in this article and their definitions is provided in the accompanying "box.")
PURPOSE OF TRANSFER PRICING Divisions of highly integrated companies typically engage in lively trade with one another, and the effect of transfer prices can be seen in most facets of operations and planning. Decisions at division level as to what products to 1. National Industrial Conference Board, Interdivisional Transfer Pricing, Business Policy Study No. 122 (New York: National Industrial Conference Board, 1967). Joel Dean, "Decentralization and Intracompany Pricing," Harvard Business Review (July-August 1955).
81
PETER MAILANDT
The following is a list of definitions of terms used in this article.
82
Product includes services, c o m p o n e n t s , subassembflies as well as finished goods. Division is a profit or cost center that is a u t o n o m o u s within a c o m p a n y with respect to procuring input products from internal or external sources. Transfer price refers to the price at which a product unit is transferred from one division to another. Total cost is the sum of all direct, indirect, and allocated cost and expenses incurred by and allocated to the division. In effect, the concept presented calls for identical cost allocation for products sold within and outside the c o m p a n y . Division profit margin is the ratio of pretax profit to sales realized by the division. Product profit margin is the profit margin the selling division w o u l d realize if it were to sell its product in a competitive, uncontrolled outside market. If no applicable outside market can be identified, a substitute " p r o d u c t profit margin" can be established, as outlined in the text. Cost markup is the supplying division's percent markup from total cost to arrive at the transfer price. Market price discount is the percent rebate from the market price at which the p r o d u c t is transferred to the purchasing division. Margin distribution index is the relative distribution of the p r o d u c t profit margin between the selling division and the buying division.
The following example illustrates the terms defined: The total cost of a product to the supplying division is assumed to be $8.40. The comparable market price is $12.00 so that the product profit margin is $3.60 or 30 percent. If the margin distribution index is set at 2, for every two dollars of profit made by the supplying division the buying division will be allowed a one-dollar discount from the market place. The transfer price is therefore set at $10.80, the cost markup is $2.40 or 28.6 percent, and the market discount is $1.20 or 10 percent. The supplying division profit margin is 22.2 percent.
manufacture at what quantities frequently depend on the profitability of "individual products relative to each other. Production of goods whose costs are expected to rise is favored by transfers at cost-plus; products with good cost reduction potential are promoted when transfer prices are tied to the market. Transfer price-dependent profitability considerations will influence make-or-buy, and may influence capital expenditure decisions at the division level, but this influence may not bring about sensible performance improvement programs at the division level unless an adequate incentive is provided for the burdened profit center. Sound transfer pricing practice should allocate profits among the participating divisions so that the profits are permitted to settle where the m o n e y has been earned. This serves two purposes; first, potentially unprofitable business units can be identified and top-level attention focused on the problem areas. Second, an objective appraisal of division performance can be complemented by an objective appraisal of the manager's performance. Although participants readily agree that sound transfer pricing policy is a key to effective business decisions, two divisions trying to protect their own interests in their interactions often find the individual requirements on transfer prices to be contradictory. The transfer price is forced into the role of being a servant for two masters. How can the need for fair financial representation of intracompany transactions be satisfied without compromising the need for effective control and for providing incentives for performance inprovement in the participating organizations? Little hope can be held for a cost or cost-plus pricing scheme that disregards market value. Nor can there be much hope for a market-value-related transfer price that rejects cost considerations. Market- and cost-oriented
BUSINESS HORIZONS
An Alternative to Transfer Pn'cing
views both must enter into developing sound intracompany transfer prices. When this is done, a relatively simple pricing scheme such as the one I am proposing can accommodate the competing interests of the interacting division as well as comply with the control and performance incentive objectives of the total enterprise.
A NEW APPROACH
The new concept is basically simple. Once a year a transfer price is agreed upon by the interacting divisions through negotiation. The negotiation, in effect, focuses on allocating the margin between the supplying division and the buying division by setting the transfer price at a level above total cost but below market price. The transfer price relative to the total cost incurred by the supplying division and relative to the comparable market price will yield the cost markup and the market price discount, respectively.. If one starts with the cost markup and the market price discount, calculation of the "product margin distribution index" is as follows: Equation A Product Margin Distribution Index = Cost Markup % (lO0--Market Discount %) Market Discount % (100 + Cost Markup %)
In the proposed method, the distribution index for the product margin is held constant throughout a designated future period. Changes in the product margin due to changes in the costs incurred by the supplying division or due to changes in the comparable market price will affect the transfer price. However, the index that characterizes the distribution of the product margin between the interacting divisions will not be allowed to change. This "automatic" adjustment of the transfer price to account for changes in cost or market price
OCTOBER 1975
is the central feature of this intracompany transfer pricing method. Other aspects will be highlighted below. The lower and the upper limits of a transfer price are, respectively, the total cost to the supplying division and th'e comparable market price of the product. The total cost associated directly and indirectly with the product is usually well known since alternative transfer price methods based on cost, as well as an effective cost control system, are dependent on accurate cost information. Establishing a comparable market price is less objective and, therefore, more difficult in instances where published or other market price data are unavailable. One of the following methods is then suggested: 1. Identify a product within the company's portfolio for which total cost and market price are available and which relates well with the product under consideration in terms of markets served, product and process technology used, and unit/dollar volume sold. The profit margin of the identified product can be substituted for the profit margin of the product under consideration. 2. If no related product can be identified, the division's overall profit margin on outside business can be taken as the profit margin of the product under consideration.
With the total profit margin established, either directly or indirectly, the task remains to decide the margin distribution index. In his article on intracompany pricing, Joel Dean offers strong arguments in favor of determining transfer prices by negotiation where all parties are fully informed, are knowledgeable, and are free to deal with the outside. The margin distribution index is then calculated from the agreed transfer price. 2 Why should the transfer price be more than cost? To provide for a profit to the supplying division and with it a performance measure. Why should the transfer price be less than market price? To provide the buying 2. Joel Dean, "Decentralization and Intracompany Pricing," p. 2.
83
PETER MAILANDT
Effects of Changes in Cost and Market Price
List or market price ($) Transfer price ($) Total cost ($) Cost markup factor Market price discount factor Margin distribution index
Product profit margin Supplying division profit margin Market price discount Change in overall margin from from column 1 Change in supplying division margin from column 1 Change in market discount from column 1
84
Bench Mark 1
2
3
10.00 9.00 7.00
10.00 8.67 6.00
12.00 10.33 7.00
10.00 9.33 8.00
9.00 8.33 7.00
12.00 10.80 8.40
.286 .100
.476 .133
.477 .139
. 167 .067
.190 .074
.286 .100
2.0
2.0
2.0
2.0
2.0
2.0
30.0% 22.2% 10.0%
40.0% 30.8% 13.3%
41.7% 32.3% 13.9%
20.0% 14.3% 6.7%
22.2% 16.0% 7.4%
30.0% 22.2% 10.0%
+33.3%
+39.0%
-33.3%
26.0%
0.0%
+38.7%
+45.5%
--35.6%
-27.9%
0.0%
+33.3%
+39.0%
-33.3%
26.0%
0.0%
division with the financial incentive to purchase inside and thus contribute to a volumerelated reduction of cost per unit. Savings are also realized by the buyer in the form of reduced purchasing activity, reduced receivables, and reduced inventory risk-all commonly associated with intracompany purchases. In the annual negotiation of the index, all contributing factors must be weighed carefully, so that the index will not be subject to change.
HOW IT WORKS
To illustrate the proposed pricing concept and its positive features, some of which are not shared by other frequently used transfer pricing schemes, a numerical example is given in the accompanying table. It shows the impact of changing costs and shifting market prices on the transfer price. At the time of the annual transfer price negotiation, the total cost of a particular product is $7.00, and the comparable open market price is $10.00. Negotiations resulted in a margin distribution index of 2, indicating that for every margin of two dollars to the supplying division, the transfer price is one
4
5
-
6
dollar less than the market price. Accordingly, the first column in the table shows a transfer price of $9.00. Also shown are: the product profit margin, 30%; the supplying division profit margin, 22.2%; and the market price discount to the buying division, 10 %. Each subsequent column in the table shows the effect of changing cost or price levels on the transfer price, the cost markup and margin claimed by the supplier, and the market discount taken by the buyer. A decrease in cost by one dollar (column 2) lowers the transfer price by $.33 to $8.67. The margin for the supplier and the discount to the buyer increase by 38.7% and 33.3%, respectively, with respect to column 1 data. A rise in market price without a change in cost level (column 3) increases the transfer price so that both divisions expand their margins. An increase of cost without a market price move (column 4) penalizes the supplier more than the buyer. Column 5 represents a situation where a rise of cost is accompanied by a decline in market price, causing margin deterioration for both participants. A 20% rise in cost coupled with a market price increase by a like percentage (column 6) raises the transfer price symmetrically, preserving margin and discount percentages.
BUSINESS HORIZONS
An Alternative to Transfer Pricing
MAJOR A D V A N T A G ES The quality and usefulness of any intracompany pricing m e t h o d can be measured by how well it satisfies each of the following four requirements. 1. Transfer pricing must be easy to manage and to administer. The proposed method calls for negotiation, say, once a year to set the margin distribution index for the subsequent twelve months. The negotiation may or may not be time-consuming depending on the complexity of the business and the people involved. After the index has been agreed upon, the impact on the transfer price of any changes in cost or market price level can be readily calculated by the administrative staff without management involvement. Updates of the transfer price can be made according to a fixed timetable or whenever changes warrant revisions. 2. The transfer price method must provide a way to measure a division performance. The proposed transfer pricing method permits divisions to retain a share of the financial benefits derived from effective cost reduction efforts. Inversely, poor cost control is reflected in decreasing margins if the cost increases cannot be passed on to the market. Consequently, division-level profits in relation to sales are good indicators of the division's operational performance and the manager's contributions to the company's overall profit objectives. 3. Transfer pricing must promote continuous performance improvement. The proposed method rewards effective cost control, successful product or process improvement, and skillful marketing efforts by increasing the profit margin at the organizational level where improvements are implemented. 4. Transfer pricing must be fair to all participants and flexible in times o f change. The proposed pricing method permits adjustment of the transfer price to equal total cost ( i n d e x = 0 ) or to approach the market price (index is very large) and can thus accomodate all interdivisional preferences, corporate guidelines, or regulations of government agencies, without changing the concept or superimposing other pricing methods on the proposed one. Since inter/zUvisional pricing changes are relatively easy administrative tasks--the margin distribution index remains u n c h a n g e d - m a r k e t price changes can be accommodated quickly and fairly with minimum disruption and without a departure from the previously'agreed upon guidelines.
"A popular argument is that a policy of transfer price bargaining is a timeconsuming, never-ending process. However, the proposed method calls for negotiations only once a year or even less frequently, since changes in cost or market prices can be accommodated administratively and do not require new bargaining." ways to measure business performance. Control of cost has to be c o m p l e m e n t e d with control over price to an extent that is acceptable to the trading partners. Only then do financial results of operations fairly reflect managerial skill as well as the division's and the product's contributions to overall corporate success or failure. Developing and promoting skills of negotiation at the division level can only enhance the competitive position of a company in the marketplace. Not surprisingly, opposition to armslength price bargaining is most often voiced by managers who fear exposure of inadequacies in the area of negotiation. A popular argument is that a policy of transfer price bargaining is a time-consuming, neverending process. However, the proposed method calls for negotiations only once a year or even less frequently, since changes in cost or market prices can be a c c o m m o d a t e d administratively and do not require new bargaining. The arms-length negotiations do require the participants' full knowledge of the total cost to the supplying division as well as the competitive market price of a like product. The bargaining could focus on establishing a transfer price, which would in turn permit calculation of the margin distribution index: Equation B Margin Distribution Index =
IMPLEMENTING THE CONCEPT The "arms-length" negotiation of interdivisional transfer prices assures independence of operating entities and leads to m e a n i n ~ u l
OCTOBER 1975
Transfer Price-Total Cost Market Price--Transfer Price
Or the negotiations could lead to an agreement as to how the margin should be divided between the trading divisions. For example, the accord may call for t w e n t y cents to the
85
PETER MAILANDT
supplying division for every dollar to the buying division, fixing the margin distribution index at .2~ The resulting transfer price would then be: Equation C Transfer Price = M g g i n Distribution Index X Market Price + Total Cost 1 + Margin Distribution Index
86
This formula would also be used when events subsequent to the agreement on the m a r ~ n index change the total cost or the market price, calling for corresponding recalculation of the transfer price. The equations in this section and the numerical example show that the transfer price follows movement of cost as well as market price changes in a compensating manner. On the one hand, manufacturing cost increases cannot be passed on in total to the next division as in the cost or cost-plus transfer price method. On the other hand, effects of market price changes will be shared by all participating divisions. The far-reaching consequence of this is that divisions at all formation stages will become rightfully concerned about the structure and dynamics of
O0 ........
cost components and the market environment of the products with which the divisions are involved. illlllllll~l"ll'lll'l The proposed transfer pricing method, which distributes the available product margin between the exchanging divisions, o f f e r s - a t the cost of only slightly increased c o m p l e x i t y - a number of operational as well as planning advantages. Operationally, the financial statements of divisions enga~ng in considerable in-house trading are heavily influenced by the transfer price policy guidelines. The proposed m e t h o d permits top management to rely on financial statements as bases for performance appraisals to a larger extent than would be warranted with the conventional transfer pricing methods. Also, comprehensive planning and forecasting processes in divisions should involve reviews of cost as well as price structure of products and services. The constant margin distribution index transfer pricing m e t h o d requires the incorporation of cost as well as price considerations in business projections. This expanded planning scope should lead to an increased awareness of the company's overall profitability and competitive position by managers at all levels.
,~,00, = = = ,O0000000000000000000CO00000QOOOOOOOOOOOOOOOOOOOOOOOOOOOOmc'~mn
There are never absolute guarantees of security. One cannot properly judge a program by asking, "Is it guaranteed to w o r k ? " A more useful criterion is the standard implied in such questions as: " U n d e r what likely circumstances are the program's results useful enough to justify its various c o s t s and dis-utilities?" - S t e p h e n Enke, ed.
Defense Management O000C~--
• • , ~ o 0 0 r ~
.....
~
. . . . . . . .
O 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 u u O 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0
BUSINESS HORIZONS