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Transfer pricing for world-class manufacturing
Transfer Pricing for World-Class Manufacturing R a l p h W. A d l e r
TODAY, MANUFACTURERSFACE AN INCREASINGLYturbulent, competitive and fast changing environment. ~ To compete successfully they must be capable of reaching a new level of performance, namely world class manufacturing. 2 The guiding principles of this manufacturing philosophy require the firm to be conscientious in finding ways to eliminate waste and continually to improve. 3 The firm's accounting and management control system should support this drive to become world class. 4 However, critics of traditional accounting practices believe that modern accounting systems do not support these programmes for continual improvement. 5 Suggestions for improving the accounting function range from supplementing traditional accounting systems with measures of performance that are broader in scope 6 and deeper in analysis 7 to changing the focus of accounting from the accumulation of costs to the provision of information about the firm's product quality, delivery performance and production process times. 8 Commentators have identified m a n y avenues for making the accounting function world class, but the role of transfer pricing has been overlooked. This oversight is unfortunate in light of the strategic blunders that can ensue from basing sourcing decisions on narrow cost/benefit analyses, where some of the costs are related to transferred-in product components from related divisions. For example, Welch & Nayak recount how US radio manufacturers' intentions to cut costs by assembling radios in Japan eventually led to the Japanese suppliers' forward integration and usurping of the US manufacturers' home country market. A market-based transfer pricing mentality, say the authors, is a foolhardy approach w h e n competitive advantage issues are at stake. 9 In spite of Welch & Nayak's calls for caution w h e n determining transfer prices, market-based prices are Pergamon 0024-6301(95)00067-4
typically perceived as the quintessential transfer price. Such prominent scholars as Solomons, 1° Anthony, Dearden, & Govindarajan, 11 and Kaplan & Atkinson 12 strongly advocate the use of market-based prices and u n a n i m o u s l y agree that they should be used whenever a competitive market exists. Their advice appears to have been accepted by the business world. The results of a survey conducted by Tang shows that market-based transfer prices are a very popular method. 13 In particular, the US Fortune 500 industrials who were surveyed indicated that they used market-based pricing for 37% of their domestic and 46% of their international transfer pricing decisions. But is it wise to recommend and so overwhelmingly use market-based transfer pricing, especially in light of the strategic concerns raised by Welch & Nayak? The purpose of this article is to illustrate the importance of strategic considerations for transfer LongRangePlanning, Vol. 29, No. 1, pp. 69 to 75, 1996 Copyright© 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0024-6301/96 $15.00+0.00
pricing decisions. As such, it begins by examining three key strategic dimensions of transfer pricing. It then depicts in tree diagram form the logical paths between these three dimensions and suitable transfer pricing methods. A discussion of the linkages between the three strategic dimensions and the reco m m e n d e d transfer price is conducted in the third section. The fourth section discusses the tree diagram's implications for practising managers.
likely to promote the early entry of competitors. As a consequence, low transfer prices, which are typically provided from cost-based transfer pricing methods, are encouraged for products that are in their early lifecycle stages. By contrast, competition will be at its peak for products that are in their maturity or decline stages. Preventing competition through the use of transfer pricing is not a viable option. Instead the firm should ensure that profit margins are being maintained. 2° The use of market-based prices is more likely to Strategic Dimensions of Transfer accomplish this goal by identifying where cost reductions can be made. Pricing The second strategic dimension that emerges from The strategic dimensions of transfer pricing have been the literature is the importance of the firm's process long overlooked in favour of transfer pricing technology for creating competitive advantage. Welsh approaches that promote economic 14 and math- & Nayak find that firms frequently neglect the impliematical programming 15 models. Only more recently cations that transfer pricing policies have on sourcing has attention been turned to the strategic issues decisions. 9 These authors are especially concerned involved in the transfer pricing and sourcing with situations whereby the firm divulges important decisions made by companies. 18 In particular, three process technology knowledge to low wage producers key strategic dimensions that emerge in the literature who can supply product components at lower costs. are the transferred good's position along the product Welch & Nayak castigate such sourcing decisions and life-cycle continuum, 17the significance of the process note the danger that such approaches have for transtechnology used to manufacture the product 9 and the forming suppliers or licensees into competitors. diversification strategy the firm employs for its As previously noted, a classic example of this shortdivisions. ~8 Each of these dimensions is discussed in term thinking occurred w h e n US radio manufacturers turn below. attempted to cut production costs by sourcing radio The transferred good's position along the product components from Japan. Eventually the Japanese life-cycle c o n t i n u u m has important implications for developed sufficient manufacturing expertise and the setting of transfer prices. ~6'19 These implications were able to successfully integrate forward. Soon the can occur at two levels. At the first and more practical Japanese were producing and selling the radios themlevel, Cats-Baril et al. demonstrate how the clarity of selves. In summary, transfer pricing methods which a reference price, and therefore the use of market fail to recognize the competitive advantage that prices, changes as the product passes from its intro- superior process technologies can provide, and duction stage through to its growth, maturity and instead concentrate on short-term cost minimization, decline phases. In other words, n e w products are typi- can severely u n d e r m i n e the firm's ability to compete. cally introduced into markets that are characterized The third strategic dimension appearing in the as 'limited' or less able to provide relevant market literature is the diversification strategy a firm prices, while more established products trade in mar- employs. Eccles posits four organizational types: colkets that are defined as 'available' or capable of pro- lective, competitive, cooperative and collaborative. 17 viding relevant market prices. These organizational types are distinguished from Spicer takes a similar approach to Cats-Baril et al. one another according to their emphasis on indew h e n he proposes that the nature of the product (rang- pendence (or diversification) and interdependence ing from highly standardized to idiosyncratic) will (or integration). Collective firms are characterized as influence the type of transfer pricing method being low on independence and interdependence. adopted. 18 In particular, highly standardized prod- Competitive firms are high on independence but low ucts will be more amenable to market-based transfer on interdependence. Cooperative firms are low on prices, while idiosyncratic products will require cost- independence but high on interdependence. And based transfer prices. finally, collaborative firms are high on both indeThe second, more strategic product life-cycle issue pendence and interdependence. concerns the fit between a transferred good's position Transfer pricing, according to Eccles, is an issue for along the product life-cycle continuum and the all organizational types except the collective form chosen transfer price. In particular, the impact of whose structure is sufficiently simple to avoid the learning curve effects on a firm's cost to manufacture transfer pricing issue altogether. Eccles believes that products should be included in the transfer price. 17 cooperatively operating divisions should use costSetting too high a transfer price during the intro- based pricing, collaborative divisions should use duction or growth stages of a product's life-cycle is mandated market-based pricing, and competitive Transfer Pricing for World-Class Manufacturing
divisions should be provided free reign to formulate transfer pricing. The third observation is that strategic their o w n pricing policies. According to Eccles, com- diversification will result in competitive divisions petitively operating divisions are most likely to resort using market-based prices, cooperative divisions using cost-based prices and collaborative divisions to market-based pricing. One final point to note about the implications of using negotiated prices. Integrating these three obserstrategic diversification for the setting of transfer vations leads to the tree diagram illustrated in Figure prices is the potential for conflict between buying and 1. (A glossary defining the transfer pricing methods selling divisions and the methods for resolving this is provided in the appendix.) In theory, the nature of the different markets means conflict. According to the work of Lawrence & Lorsch, firms that operate in more uncertain environments that n e w products require cost-based or negotiated respond by altering their organizational structure so transfer prices, but established products can use the as to cope more effectively with the demands of the full range of transfer pricing methods. In reality, howuncertain environment and technology. This process ever, the feasible set of transfer pricing methods is is called differentiation. Of course, to be successful much smaller. For instance, while it may be beneficial firms must not only achieve the correct amount of to encourage the use of low, cost-based transfer prices differentiation, they must also ensure that their div- for newly introduced products, so that purchasing divisions are encouraged to b u y internally and preisions operate in a cohesive and coordinated manner. This process is called integration. Firms whose div- vent the creation of n e w competitors, the use of low isions operate in a collaborative manner, facing high transfer prices w h e n the product is well-established is likely to do more harm than good. The markets for amounts of diversification and vertical integration, are most in need of integrating mechanisms. 21 Watson well-established products are generally more com& Baumler have argued, therefore, that these divisions petitive, and it is difficult to preempt competition. are most likely to benefit from the integrating features The use of cost-based transfer prices for established inherent in a negotiated transfer pricing method. The products can, however, have serious negative effects. process of negotiation provides a valuable dose of In particular, cost-based transfer pricing systems can integration. 22 encourage an attitude of complacency. Managers in Based on the conclusions reached by Lawrence & sales divisions who realize that their costs will be Lorsch and Watson & Baumler, it w o u l d appear that borne by units further downstream from themselves negotiated transfer prices for collaborative divisions may see no need to eliminate inefficiencies in their are more in harmony with Eccles belief that 'sup- own operations. 17 Thus, the need to support a propressing or alleviating conflict b e y o n d a certain point gramme of continual improvement may encourage a actually becomes undesirable' (p. 120) than his sug- firm's use of market-based transfer prices for wellgested method of mandated market prices. 17 It w o u l d established products. In summary, a transferred product's position in its appear that negotiated prices are well suited to offering transacting divisions operating in uncertain product life-cycle, strongly influences whether the environments the opportunity to talk over their dif- transfer price should be cost-based or market-based. ferences and, in the process, better understand what Sometimes a n e w product cannot have a price detereach division must do to promote overall firm effec- mined by the market, and a form of cost-based or tiveness. 21 negotiated transfer price may be the only viable choice. While established products are amenable to a full range of transfer pricing methods, strategic considerations may limit the alternatives to market-based Linking the Key Strategic transfer prices. For this reason a dotted 'boundary' line in Figure 1 runs between the product life-cycle Dimensions to Transfer Pricing stages termed 'new' and 'established'. Multiproduct Methods firms will probably apply different transfer pricing Three important observations can be made from the methods to each of their products depending on the above discussion on the strategic dimensions of trans- considerations previously mentioned. fer pricing. Firstly, transfer prices for newly introduced products should tend toward cost-based transfer prices, while transfer prices for more estab- The Strategic Dimensions of lished products should tend toward market prices. Transfer Pricing Secondly, careless transfer pricing can imperil a firm's competitive advantage. When the firm relies This section is devoted to a discussion of the links heavily on its process technology for competitive b e t w e e n the strategic dimensions mentioned in advantage, transfer prices should be used that will Figure 1 and the r e c o m m e n d e d transfer price. The encourage the sustainment of its competitive advan- rationale for each transfer price is discussed below. Branch 1 suggests a transfer price that uses costs, tage. Generally this will involve using cost-based Long Range Planning Vol. 29
February 1996
including opportunity costs. Since the product is new, a cost-based transfer price is appropriate. Cost is also appropriate since the significance of the process technology is high. Finally, since the divisions are acting in a competitive manner, it is suggested that the costs involved include opportunity costs. This way the supplying division will be no worse off from supplying its sister division then if it used its plant capacity to attend to other customers. Branch 2 recommends the use ofa costplus share of profits transfer price. The use of a cost-based transfer price is warranted because of the newness of the product. Additionally, a cost-based transfer price is encouraged by the fact that the process technology is highly related to the firm's competitive advantage. Finally, because the subsidiaries or divisions operate in a cooperative manner, it is important that the business unit which sells the product to the customer be aware of the actual, out-of-pocket costs of manufacturing the product, w h e n it sets the sales price. Following the sale of the product to the customer, the cooperating divisions will share in the profits obtained. Branch 3 advises the use of negotiated prices. Again, because the product is new and the sigTransfer Pricing for World-Class Manufacturing
nificance of the process technology is high, the use of market-based transfer prices would not be appropriate. The collaborative nature of the divisions, and the especially important need for integrating mechanisms for these highly differentiated subsidiaries, leads to the adoption of negotiated prices. In fact, the benefits from using negotiated transfer prices as an integrating mechanism for highly differentiated business units are so critical that negotiated transfer pricing is the recommended method for each of the other branches that contain collaborative settings. As a consequence, branches 6, 9, and 12 will not be discussed. Branch 4 suggests a price based on cost, including opportunity costs. Again, the new nature of the product dictates the use of cost and precludes the idea of using a market-based transfer price, in spite of the fact that there is a low significance of process technology for competitive advantage. The competitive nature of the business units requires that the selling division should be fully compensated for its efforts, including opportunity costs. Branch 5 proposes the use of cost, plus share of profits. Similar to the rationale provided with the branch 4 explanation about the nature of the product
life-cycle and the firm's reliance on process technology for competitive advantage, a cost-based transfer price is warranted. Due to the cooperative structuring of the division, it is crucial that the selling subdivision knows the actual, out-of-pocket costs for its pricing decisions. Dual pricing is the advised transfer pricing method for branch 7. The product is established, and therefore market prices are available. Since the firm relies heavily on its process technology for competitive advantage, it is important that the transfer pricing method encourage internal sourcing, such as cost typically does. Finally, because of the competitive structuring of the business units, it is helpful to treat the two divisions as if they were two separate entities operating under the concept of arms-length transactions. Dual pricing achieves all these necessary requirements by charging the buying division for the selling division's costs and crediting the selling division with the market price. Branch 8 recommends the use of two-step pricing. The existence of an established product means that external customer d e m a n d for the product is more likely to be stable than for products that are new. Under these conditions, the buying division has a relatively clear idea of the amount of plant capacity it will require from the supplying division. Since the significance of the process technology is high, a costbased price is desired as a means of encouraging internal sourcing. Due to the cooperative nature of the subsidiaries, the competition that market prices generally engender is not advised. Market pricing is the suggested transfer price for branch 10. The product is established and the process technology has low significance for competitive advantage. Market pricing w o u l d provide the best indication of the contributions made by each division and indicate what divisions might be discontinued without losing competitive advantage. For branch 11, market pricing, is the r e c o m m e n d e d transfer price. The product is established and the process technology is not needed for competitive advantage. While these firms are linked in a cooperative chain, the need continually to improve and become more cost efficient is typically missing in cost-based transfer prices. The managements of subsidiaries must realize that the product's stage in its life-cycle and the firm's process technology are relatively unimportant for competitive advantage, and they must be willing to meet market prices or face closure.
Practical Implications for Managers The diagram is intended to link strategic considerations to existing transfer pricing methods. The tree diagram is designed to help a manager to link his or her company's strategies with suitable transfer
pricing methods and should provide managers with insights into strategic issues that have been largely ignored in the past. The model should be used more as a guide than followed in a mechanistic way. This is especially true for situations in which the product is n e w and/or the significance of process technology for competitive advantage is high. As an example, transfer prices for n e w products computed using today's actual costs, versus tomorrow's improved costs, are more likely to encourage the early entrance of competitors. Consequently, senior management may find they need to play a more active role in the setting of transfer prices. One w a y in w h i c h senior managers could nurture the internal sourcing of products is through the definition of cost-based transfer prices. In particular, senior managers might choose to define cost as variable costs. Fixed costs, such as R&D, amortization of intangibles and general overheads, w o u l d be excluded. A minor tinkering with the definition of 'costs', however, will not always be sufficient. On certain occasions senior managers will find they need to be less concerned with demonstrating the accounting defensibility of their transfer pricing choices and more concerned with the strategic consequences of the sourcing decisions. Under these circumstances, senior managers may need to step in and mandate transfer prices. Of course, the intervention of senior managers in the transfer pricing decision is likely to have implications for the process of evaluating subordinate performance. As Spiller very passionately and persuasively argued several years ago, it is unfair to hold managers responsible for uncontrollable factors, such as mandated costs. 23 Thus, as a superior's intervention into the setting of transfer prices increases and the subordinate's influence decreases, senior managers will find they need to move away from a bottom-line or budget-constrained mentality. In particular, traditional accounting performance measures that have not been adjusted for controllable items, as is typical with such measures as return on capital employed and other profitability ratios, should be avoided. In their place, senior managers may wish to use specially tailored non-financial measures that can be developed from Kaplan and Norton's balanced scorecard. 6 Tax implications, at least for multinationals, represent another important consideration that senior management must keep in mind. Strategically determined transfer prices may run counter to the firm's wish to minimize taxes (i.e. to shift profits to low tax countries) and the taxing authorities' rules. There is nothing to prevent a firm from using different transfer pricing methods for tax purposes. The presence of multiple transfer prices could, in the event of a tax audit, complicate the firm's ability to demonstrate to Long Range Planning Vol. 29
February 1996
the taxing authorities the reasonab]eness of its transfer pricing method. Consequently, firms need to make a conscious choice of where to locate themselves along the c o n t i n u u m between 'sticking to the knitting' and using their financial finesse to optimize profits by minimizing taxes. In summary, the model offers managers a new perspective, namely a strategic approach, to viewing transfer pricing issues. As with any model, it sim-
plifies the environment it wishes to represent. Accordingly, managers should be guided and not constrained by its prescriptions. A healthy dose of managerial discretion and prudence should be used in concert with the model's transfer pricing prescriptions. The author gratefully acknowledges the helpful comments that were provided by Alan MacGregorand Markus Milne. All errors, of course, remain the sole responsibilityof the author.
A p p e n d i x : Glossary of transfer pricing methods
Cost Basis:
The actual or standard cost to manufacture a product is used as the basis for d e t e r m i n i n g a transfer price.
D u a l pricing:
The selling division records the internal sale at the current market price, w h i l e the buying division records the purchase at either the selling d i v i s i o n ' s actual or standard cost to manufacture the product.
M a r k e t prices:
The internal transfer price equals the price that outside companies w o u l d charge for producing an identical product.
N e g o t i a t e d prices:
The buying and selling division reach a mutual agreement about w h a t the internal transfer price should be.
Two-step:
The transfer price is the sum of t w o separate charges. The first is equal to the standard variable cost to manufacture the product. The second charge is based on the percentage of the selling d i v i s i o n s ' s production capacity that is reserved for the buying d i v i s i o n ' s purchasing requirements.
References 1. R.H. Hayes and G.P. Pisano, Beyond world class: the new manufacturing strategy, Harvard Business Review, 77-86 (1994). 2. R. Schonberger, World Class Manufacturing, The Free Press, New York (1986). 3. M. Sweeney, Strategic manufacturing management: restructuring wasteful production to world class, Journal of General Management, 57-76 (1993). 4. B. Maskell, Performance measurement for world class manufacturing, Management Accounting, May, 32-33 (1989); B. Maskell, Performance measurement for world class manufacturing--2, Management Accounting, June, 32-33 (1989); B. Maskell, Performance measurement for world class manufacturing--3, Management Accounting, July/August, 49-50 (1989); and B. Maskell, Performance measurement for world class manufacturing--4, Management Accounting, September, 64-66 (1989). 5. H. Johnson and R. Kaplan, Relevance Lost, Harvard Business School Press, Boston (1987). 6. See, for example, Kaplan and Norton's balanced scorecard approach in R. Kaplan and D. Norton, Putting the balanced scorecard to work, Harvard Business Review, 134-142 (1993). 7. See, for example, Taguchi and Clausing's cost of quality concept in G. Taguchi, and D. Clausing, Robust quality, Harvard Business Review, 68-75 (1990). 8. B. Maskell, Performance measurement for world class manufacturing--3, Management Accounting, July/August, 49-50 (1989). 9. J.A. Welch and P.R. Nayak, Strategic sourcing: a progressive approach to the make-orbuy decision, Academy of Management Executive, 23-31 (1992). 10. D. Solomons, Divisional performance measurement and control, Irwin, Homewood, IL (1965). 11. R. Anthony, J. Dearden, and V. Govindarajan, Management Control Systems, Irwin, Homewood, IL (1992). 12. R. Kaplan and A. Atkinson, Advanced Management Accounting, Prentice Hall, Englewood Cliffs, NJ (1989).
Transfer Pricing for World-Class Manufacturing
13. Tang, Transfer pricing in the 1990s. Management Accounting, Feb, 22-26 (1992). 14. J. Hirshleifer, On the economics of transfer pricing, Journal of Business, 172-184 (1956). 15. W. Baumol, and T. Fabian, Decomposition pricing for decentralization and external economies, Management Science, 1-13 (1964); and J. Hass, Transfer pricing in a decentralized firm, Management Science, B310-B333 (1968). 16. J.A. Welch and P.R. Nayak, Strategic sourcing: a progressive approach to the make-orbuy decision, Academy of Management Executive, 23-31 (1992); T. Elfring and G. Baven, Outsourcing technical services: stages in development, Long Range Planning 27 (5), 4251 (1994); R. Speckman, J. Kamauff, and D. Salmond, At last purchasing is becoming strategic, Long Range Planning, 27 (2), 76-84 (1994). 17. W. Cats-Baril, J. Gatti, and D. Grinnell, Transfer pricing in a dynamic environment, Management Accounting, 30-33 (1988). 18. R. Eccles, Control with fairness in transfer pricing, Harvard Business Review, 111-123 (1983). 19. B. Spicer, Towards an organizational theory of the transfer pricing process, Accounting, Organizations and Society, 303-322 (1988). 20. V. Govindarajan, and A. Gupta, Linking control systems to business unit strategy: impact on performance, Accounting, Organizations and Society, 51-66 (1985).
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21. P. Lawrence, and J. Lorsch, Organization and Environment, Irwin, Homewood, IL (1967). 22. D. Watson, and J. Baumler, Transfer pricing: a behavioral context, The Accounting Review, 466-474 (1975). 23. E. Spiller, Return on investment, Accounting Horizons, pp. 1-9 (1988).
Long Range Planning Vol. 29
February 1996
TODAY, MANUFACTURERSFACE AN INCREASINGLYturbulent, competitive and fast changing environment. ~ To compete successfully they must be capable of reaching a new level of performance, namely world class manufacturing. 2 The guiding principles of this manufacturing philosophy require the firm to be conscientious in finding ways to eliminate waste and continually to improve. 3 The firm's accounting and management control system should support this drive to become world class. 4 However, critics of traditional accounting practices believe that modern accounting systems do not support these programmes for continual improvement. 5 Suggestions for improving the accounting function range from supplementing traditional accounting systems with measures of performance that are broader in scope 6 and deeper in analysis 7 to changing the focus of accounting from the accumulation of costs to the provision of information about the firm's product quality, delivery performance and production process times. 8 Commentators have identified m a n y avenues for making the accounting function world class, but the role of transfer pricing has been overlooked. This oversight is unfortunate in light of the strategic blunders that can ensue from basing sourcing decisions on narrow cost/benefit analyses, where some of the costs are related to transferred-in product components from related divisions. For example, Welch & Nayak recount how US radio manufacturers' intentions to cut costs by assembling radios in Japan eventually led to the Japanese suppliers' forward integration and usurping of the US manufacturers' home country market. A market-based transfer pricing mentality, say the authors, is a foolhardy approach w h e n competitive advantage issues are at stake. 9 In spite of Welch & Nayak's calls for caution w h e n determining transfer prices, market-based prices are Pergamon 0024-6301(95)00067-4
typically perceived as the quintessential transfer price. Such prominent scholars as Solomons, 1° Anthony, Dearden, & Govindarajan, 11 and Kaplan & Atkinson 12 strongly advocate the use of market-based prices and u n a n i m o u s l y agree that they should be used whenever a competitive market exists. Their advice appears to have been accepted by the business world. The results of a survey conducted by Tang shows that market-based transfer prices are a very popular method. 13 In particular, the US Fortune 500 industrials who were surveyed indicated that they used market-based pricing for 37% of their domestic and 46% of their international transfer pricing decisions. But is it wise to recommend and so overwhelmingly use market-based transfer pricing, especially in light of the strategic concerns raised by Welch & Nayak? The purpose of this article is to illustrate the importance of strategic considerations for transfer LongRangePlanning, Vol. 29, No. 1, pp. 69 to 75, 1996 Copyright© 1996 Elsevier Science Ltd Printed in Great Britain. All rights reserved 0024-6301/96 $15.00+0.00
pricing decisions. As such, it begins by examining three key strategic dimensions of transfer pricing. It then depicts in tree diagram form the logical paths between these three dimensions and suitable transfer pricing methods. A discussion of the linkages between the three strategic dimensions and the reco m m e n d e d transfer price is conducted in the third section. The fourth section discusses the tree diagram's implications for practising managers.
likely to promote the early entry of competitors. As a consequence, low transfer prices, which are typically provided from cost-based transfer pricing methods, are encouraged for products that are in their early lifecycle stages. By contrast, competition will be at its peak for products that are in their maturity or decline stages. Preventing competition through the use of transfer pricing is not a viable option. Instead the firm should ensure that profit margins are being maintained. 2° The use of market-based prices is more likely to Strategic Dimensions of Transfer accomplish this goal by identifying where cost reductions can be made. Pricing The second strategic dimension that emerges from The strategic dimensions of transfer pricing have been the literature is the importance of the firm's process long overlooked in favour of transfer pricing technology for creating competitive advantage. Welsh approaches that promote economic 14 and math- & Nayak find that firms frequently neglect the impliematical programming 15 models. Only more recently cations that transfer pricing policies have on sourcing has attention been turned to the strategic issues decisions. 9 These authors are especially concerned involved in the transfer pricing and sourcing with situations whereby the firm divulges important decisions made by companies. 18 In particular, three process technology knowledge to low wage producers key strategic dimensions that emerge in the literature who can supply product components at lower costs. are the transferred good's position along the product Welch & Nayak castigate such sourcing decisions and life-cycle continuum, 17the significance of the process note the danger that such approaches have for transtechnology used to manufacture the product 9 and the forming suppliers or licensees into competitors. diversification strategy the firm employs for its As previously noted, a classic example of this shortdivisions. ~8 Each of these dimensions is discussed in term thinking occurred w h e n US radio manufacturers turn below. attempted to cut production costs by sourcing radio The transferred good's position along the product components from Japan. Eventually the Japanese life-cycle c o n t i n u u m has important implications for developed sufficient manufacturing expertise and the setting of transfer prices. ~6'19 These implications were able to successfully integrate forward. Soon the can occur at two levels. At the first and more practical Japanese were producing and selling the radios themlevel, Cats-Baril et al. demonstrate how the clarity of selves. In summary, transfer pricing methods which a reference price, and therefore the use of market fail to recognize the competitive advantage that prices, changes as the product passes from its intro- superior process technologies can provide, and duction stage through to its growth, maturity and instead concentrate on short-term cost minimization, decline phases. In other words, n e w products are typi- can severely u n d e r m i n e the firm's ability to compete. cally introduced into markets that are characterized The third strategic dimension appearing in the as 'limited' or less able to provide relevant market literature is the diversification strategy a firm prices, while more established products trade in mar- employs. Eccles posits four organizational types: colkets that are defined as 'available' or capable of pro- lective, competitive, cooperative and collaborative. 17 viding relevant market prices. These organizational types are distinguished from Spicer takes a similar approach to Cats-Baril et al. one another according to their emphasis on indew h e n he proposes that the nature of the product (rang- pendence (or diversification) and interdependence ing from highly standardized to idiosyncratic) will (or integration). Collective firms are characterized as influence the type of transfer pricing method being low on independence and interdependence. adopted. 18 In particular, highly standardized prod- Competitive firms are high on independence but low ucts will be more amenable to market-based transfer on interdependence. Cooperative firms are low on prices, while idiosyncratic products will require cost- independence but high on interdependence. And based transfer prices. finally, collaborative firms are high on both indeThe second, more strategic product life-cycle issue pendence and interdependence. concerns the fit between a transferred good's position Transfer pricing, according to Eccles, is an issue for along the product life-cycle continuum and the all organizational types except the collective form chosen transfer price. In particular, the impact of whose structure is sufficiently simple to avoid the learning curve effects on a firm's cost to manufacture transfer pricing issue altogether. Eccles believes that products should be included in the transfer price. 17 cooperatively operating divisions should use costSetting too high a transfer price during the intro- based pricing, collaborative divisions should use duction or growth stages of a product's life-cycle is mandated market-based pricing, and competitive Transfer Pricing for World-Class Manufacturing
divisions should be provided free reign to formulate transfer pricing. The third observation is that strategic their o w n pricing policies. According to Eccles, com- diversification will result in competitive divisions petitively operating divisions are most likely to resort using market-based prices, cooperative divisions using cost-based prices and collaborative divisions to market-based pricing. One final point to note about the implications of using negotiated prices. Integrating these three obserstrategic diversification for the setting of transfer vations leads to the tree diagram illustrated in Figure prices is the potential for conflict between buying and 1. (A glossary defining the transfer pricing methods selling divisions and the methods for resolving this is provided in the appendix.) In theory, the nature of the different markets means conflict. According to the work of Lawrence & Lorsch, firms that operate in more uncertain environments that n e w products require cost-based or negotiated respond by altering their organizational structure so transfer prices, but established products can use the as to cope more effectively with the demands of the full range of transfer pricing methods. In reality, howuncertain environment and technology. This process ever, the feasible set of transfer pricing methods is is called differentiation. Of course, to be successful much smaller. For instance, while it may be beneficial firms must not only achieve the correct amount of to encourage the use of low, cost-based transfer prices differentiation, they must also ensure that their div- for newly introduced products, so that purchasing divisions are encouraged to b u y internally and preisions operate in a cohesive and coordinated manner. This process is called integration. Firms whose div- vent the creation of n e w competitors, the use of low isions operate in a collaborative manner, facing high transfer prices w h e n the product is well-established is likely to do more harm than good. The markets for amounts of diversification and vertical integration, are most in need of integrating mechanisms. 21 Watson well-established products are generally more com& Baumler have argued, therefore, that these divisions petitive, and it is difficult to preempt competition. are most likely to benefit from the integrating features The use of cost-based transfer prices for established inherent in a negotiated transfer pricing method. The products can, however, have serious negative effects. process of negotiation provides a valuable dose of In particular, cost-based transfer pricing systems can integration. 22 encourage an attitude of complacency. Managers in Based on the conclusions reached by Lawrence & sales divisions who realize that their costs will be Lorsch and Watson & Baumler, it w o u l d appear that borne by units further downstream from themselves negotiated transfer prices for collaborative divisions may see no need to eliminate inefficiencies in their are more in harmony with Eccles belief that 'sup- own operations. 17 Thus, the need to support a propressing or alleviating conflict b e y o n d a certain point gramme of continual improvement may encourage a actually becomes undesirable' (p. 120) than his sug- firm's use of market-based transfer prices for wellgested method of mandated market prices. 17 It w o u l d established products. In summary, a transferred product's position in its appear that negotiated prices are well suited to offering transacting divisions operating in uncertain product life-cycle, strongly influences whether the environments the opportunity to talk over their dif- transfer price should be cost-based or market-based. ferences and, in the process, better understand what Sometimes a n e w product cannot have a price detereach division must do to promote overall firm effec- mined by the market, and a form of cost-based or tiveness. 21 negotiated transfer price may be the only viable choice. While established products are amenable to a full range of transfer pricing methods, strategic considerations may limit the alternatives to market-based Linking the Key Strategic transfer prices. For this reason a dotted 'boundary' line in Figure 1 runs between the product life-cycle Dimensions to Transfer Pricing stages termed 'new' and 'established'. Multiproduct Methods firms will probably apply different transfer pricing Three important observations can be made from the methods to each of their products depending on the above discussion on the strategic dimensions of trans- considerations previously mentioned. fer pricing. Firstly, transfer prices for newly introduced products should tend toward cost-based transfer prices, while transfer prices for more estab- The Strategic Dimensions of lished products should tend toward market prices. Transfer Pricing Secondly, careless transfer pricing can imperil a firm's competitive advantage. When the firm relies This section is devoted to a discussion of the links heavily on its process technology for competitive b e t w e e n the strategic dimensions mentioned in advantage, transfer prices should be used that will Figure 1 and the r e c o m m e n d e d transfer price. The encourage the sustainment of its competitive advan- rationale for each transfer price is discussed below. Branch 1 suggests a transfer price that uses costs, tage. Generally this will involve using cost-based Long Range Planning Vol. 29
February 1996
including opportunity costs. Since the product is new, a cost-based transfer price is appropriate. Cost is also appropriate since the significance of the process technology is high. Finally, since the divisions are acting in a competitive manner, it is suggested that the costs involved include opportunity costs. This way the supplying division will be no worse off from supplying its sister division then if it used its plant capacity to attend to other customers. Branch 2 recommends the use ofa costplus share of profits transfer price. The use of a cost-based transfer price is warranted because of the newness of the product. Additionally, a cost-based transfer price is encouraged by the fact that the process technology is highly related to the firm's competitive advantage. Finally, because the subsidiaries or divisions operate in a cooperative manner, it is important that the business unit which sells the product to the customer be aware of the actual, out-of-pocket costs of manufacturing the product, w h e n it sets the sales price. Following the sale of the product to the customer, the cooperating divisions will share in the profits obtained. Branch 3 advises the use of negotiated prices. Again, because the product is new and the sigTransfer Pricing for World-Class Manufacturing
nificance of the process technology is high, the use of market-based transfer prices would not be appropriate. The collaborative nature of the divisions, and the especially important need for integrating mechanisms for these highly differentiated subsidiaries, leads to the adoption of negotiated prices. In fact, the benefits from using negotiated transfer prices as an integrating mechanism for highly differentiated business units are so critical that negotiated transfer pricing is the recommended method for each of the other branches that contain collaborative settings. As a consequence, branches 6, 9, and 12 will not be discussed. Branch 4 suggests a price based on cost, including opportunity costs. Again, the new nature of the product dictates the use of cost and precludes the idea of using a market-based transfer price, in spite of the fact that there is a low significance of process technology for competitive advantage. The competitive nature of the business units requires that the selling division should be fully compensated for its efforts, including opportunity costs. Branch 5 proposes the use of cost, plus share of profits. Similar to the rationale provided with the branch 4 explanation about the nature of the product
life-cycle and the firm's reliance on process technology for competitive advantage, a cost-based transfer price is warranted. Due to the cooperative structuring of the division, it is crucial that the selling subdivision knows the actual, out-of-pocket costs for its pricing decisions. Dual pricing is the advised transfer pricing method for branch 7. The product is established, and therefore market prices are available. Since the firm relies heavily on its process technology for competitive advantage, it is important that the transfer pricing method encourage internal sourcing, such as cost typically does. Finally, because of the competitive structuring of the business units, it is helpful to treat the two divisions as if they were two separate entities operating under the concept of arms-length transactions. Dual pricing achieves all these necessary requirements by charging the buying division for the selling division's costs and crediting the selling division with the market price. Branch 8 recommends the use of two-step pricing. The existence of an established product means that external customer d e m a n d for the product is more likely to be stable than for products that are new. Under these conditions, the buying division has a relatively clear idea of the amount of plant capacity it will require from the supplying division. Since the significance of the process technology is high, a costbased price is desired as a means of encouraging internal sourcing. Due to the cooperative nature of the subsidiaries, the competition that market prices generally engender is not advised. Market pricing is the suggested transfer price for branch 10. The product is established and the process technology has low significance for competitive advantage. Market pricing w o u l d provide the best indication of the contributions made by each division and indicate what divisions might be discontinued without losing competitive advantage. For branch 11, market pricing, is the r e c o m m e n d e d transfer price. The product is established and the process technology is not needed for competitive advantage. While these firms are linked in a cooperative chain, the need continually to improve and become more cost efficient is typically missing in cost-based transfer prices. The managements of subsidiaries must realize that the product's stage in its life-cycle and the firm's process technology are relatively unimportant for competitive advantage, and they must be willing to meet market prices or face closure.
Practical Implications for Managers The diagram is intended to link strategic considerations to existing transfer pricing methods. The tree diagram is designed to help a manager to link his or her company's strategies with suitable transfer
pricing methods and should provide managers with insights into strategic issues that have been largely ignored in the past. The model should be used more as a guide than followed in a mechanistic way. This is especially true for situations in which the product is n e w and/or the significance of process technology for competitive advantage is high. As an example, transfer prices for n e w products computed using today's actual costs, versus tomorrow's improved costs, are more likely to encourage the early entrance of competitors. Consequently, senior management may find they need to play a more active role in the setting of transfer prices. One w a y in w h i c h senior managers could nurture the internal sourcing of products is through the definition of cost-based transfer prices. In particular, senior managers might choose to define cost as variable costs. Fixed costs, such as R&D, amortization of intangibles and general overheads, w o u l d be excluded. A minor tinkering with the definition of 'costs', however, will not always be sufficient. On certain occasions senior managers will find they need to be less concerned with demonstrating the accounting defensibility of their transfer pricing choices and more concerned with the strategic consequences of the sourcing decisions. Under these circumstances, senior managers may need to step in and mandate transfer prices. Of course, the intervention of senior managers in the transfer pricing decision is likely to have implications for the process of evaluating subordinate performance. As Spiller very passionately and persuasively argued several years ago, it is unfair to hold managers responsible for uncontrollable factors, such as mandated costs. 23 Thus, as a superior's intervention into the setting of transfer prices increases and the subordinate's influence decreases, senior managers will find they need to move away from a bottom-line or budget-constrained mentality. In particular, traditional accounting performance measures that have not been adjusted for controllable items, as is typical with such measures as return on capital employed and other profitability ratios, should be avoided. In their place, senior managers may wish to use specially tailored non-financial measures that can be developed from Kaplan and Norton's balanced scorecard. 6 Tax implications, at least for multinationals, represent another important consideration that senior management must keep in mind. Strategically determined transfer prices may run counter to the firm's wish to minimize taxes (i.e. to shift profits to low tax countries) and the taxing authorities' rules. There is nothing to prevent a firm from using different transfer pricing methods for tax purposes. The presence of multiple transfer prices could, in the event of a tax audit, complicate the firm's ability to demonstrate to Long Range Planning Vol. 29
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the taxing authorities the reasonab]eness of its transfer pricing method. Consequently, firms need to make a conscious choice of where to locate themselves along the c o n t i n u u m between 'sticking to the knitting' and using their financial finesse to optimize profits by minimizing taxes. In summary, the model offers managers a new perspective, namely a strategic approach, to viewing transfer pricing issues. As with any model, it sim-
plifies the environment it wishes to represent. Accordingly, managers should be guided and not constrained by its prescriptions. A healthy dose of managerial discretion and prudence should be used in concert with the model's transfer pricing prescriptions. The author gratefully acknowledges the helpful comments that were provided by Alan MacGregorand Markus Milne. All errors, of course, remain the sole responsibilityof the author.
A p p e n d i x : Glossary of transfer pricing methods
Cost Basis:
The actual or standard cost to manufacture a product is used as the basis for d e t e r m i n i n g a transfer price.
D u a l pricing:
The selling division records the internal sale at the current market price, w h i l e the buying division records the purchase at either the selling d i v i s i o n ' s actual or standard cost to manufacture the product.
M a r k e t prices:
The internal transfer price equals the price that outside companies w o u l d charge for producing an identical product.
N e g o t i a t e d prices:
The buying and selling division reach a mutual agreement about w h a t the internal transfer price should be.
Two-step:
The transfer price is the sum of t w o separate charges. The first is equal to the standard variable cost to manufacture the product. The second charge is based on the percentage of the selling d i v i s i o n s ' s production capacity that is reserved for the buying d i v i s i o n ' s purchasing requirements.
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Transfer Pricing for World-Class Manufacturing
13. Tang, Transfer pricing in the 1990s. Management Accounting, Feb, 22-26 (1992). 14. J. Hirshleifer, On the economics of transfer pricing, Journal of Business, 172-184 (1956). 15. W. Baumol, and T. Fabian, Decomposition pricing for decentralization and external economies, Management Science, 1-13 (1964); and J. Hass, Transfer pricing in a decentralized firm, Management Science, B310-B333 (1968). 16. J.A. Welch and P.R. Nayak, Strategic sourcing: a progressive approach to the make-orbuy decision, Academy of Management Executive, 23-31 (1992); T. Elfring and G. Baven, Outsourcing technical services: stages in development, Long Range Planning 27 (5), 4251 (1994); R. Speckman, J. Kamauff, and D. Salmond, At last purchasing is becoming strategic, Long Range Planning, 27 (2), 76-84 (1994). 17. W. Cats-Baril, J. Gatti, and D. Grinnell, Transfer pricing in a dynamic environment, Management Accounting, 30-33 (1988). 18. R. Eccles, Control with fairness in transfer pricing, Harvard Business Review, 111-123 (1983). 19. B. Spicer, Towards an organizational theory of the transfer pricing process, Accounting, Organizations and Society, 303-322 (1988). 20. V. Govindarajan, and A. Gupta, Linking control systems to business unit strategy: impact on performance, Accounting, Organizations and Society, 51-66 (1985).
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21. P. Lawrence, and J. Lorsch, Organization and Environment, Irwin, Homewood, IL (1967). 22. D. Watson, and J. Baumler, Transfer pricing: a behavioral context, The Accounting Review, 466-474 (1975). 23. E. Spiller, Return on investment, Accounting Horizons, pp. 1-9 (1988).
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February 1996