If you work for a diversified group, chances are you are somehow involved in transfer pricing, a tricky process whereby appropriate prices for intra-group trading are set. Let’s have a look at how it works and, importantly, how it can lead to wrong decisions.
How does transfer pricing work?
Diversified groups are divided into numerous smaller units that report their performance independently. Each of these units is a profit centre, and each reports results for its own sphere of activities. Each of these profit centres also pays tax on their profits. Large multinational groups usually own individual companies established in different countries and each of these subsidiaries are profit centres.
As these profit centres trade between each other, there must be a process of deciding on appropriate prices for the goods and services sold intra-group. This process is what we call Transfer Pricing.
You will appreciate that there are tax, motivational and legal influences on such price decisions.
Look at this example and see how transfer pricing could lead us to wrong decisions:
A company C has two divisions – CH and J. Division CH manufactures a product which it transfers (i.e. sells) to Division J at a transfer price equal to the total cost of manufacture in Division CH. Division J incorporates each unit bought (transferred) from Division CH into a product which J manufactures and sells. Assume that divisions CH and J currently have spare production capacity i.e. they can meet a little more demand.
The cost and selling price data are:
If now an opportunity arose for Division J to sell to a client the same product for $10 per unit, without affecting its normal existing business and its selling price of $15 per unit on that business, the manager of Division J would reject it, as the divisional profit would fall. The total cost per unit of $14 would exceed the selling price of $10.
Would you reject this opportunity and send the client to competition? Or perhaps is this not an opportunity after all?
We know about contribution from previous articles. If the general manager of the whole group applied a contribution approach, they might argue that the additional business is worthwhile because it would still make a contribution towards fixed costs. The calculations would be based on:
What is happening is that the manager of J perceives the transfer price of $5 as a variable cost, that is as a cost that only happens if production or sales happen! The reality is that not all of the $5 comprises variable costs from the point of view of the whole enterprise. So we have to appreciate that there are two perspectives from which the described transfer pricing can be perceived. How does this affect Company C?
How do you ensure sound decision-making with transfer pricing?
In the above example, we need a process owner that would oversee the two divisions and direct them to agree on the transfer price. As far as the making of optimal decisions is concerned, a transfer price based on total cost is to be avoided.
Of course, based on ideal examples, the above is easy to say. In practice there are many issues that need to be resolved before finding an optimum level of the transfer price.
In later articles we will show how other types of transfer pricing like market-based prices or negotiated and dual prices affect business decisions. In the meantime, please let us know if you have any questions or comments on this aspect of financial management in the space below!