Business Facets of Transfer Pricing

Robert Feinschreiber

A. 1 INTRODUCTION

This chapter examines the business facets of transfer pricing. In so doing, we must examine the transfer pricing techniques that apply to intracompany divisions and profit centers as well as to intercompany transfers. To undertake this analysis, we must transcend, but not challenge, the requirements of the transfer pricing regulations.

Intracompany transfer pricing must address such issues as the measuring, evaluating, and rewarding of the performance of a business segment and its leaders. These performance measures are most often reflected by personnel policies, incentives, bonuses, and the like. These performance issues, which include the above-mentioned factors and the components that comprise corporate culture, are not limited to tax saving or to double taxation. In fact, intracompany transfer pricing applies to transfers between corporate divisions and profit centers, and applies even if the divisions or profit centers are located in a single jurisdiction and are devoid of tax issues.

(a) Basic Distinctions

There is an inherent practical distinction between intercompany transfer pricing and intracompany transfer pricing. The transfer pricing regulations issued by the U. S. Treasury Department (Treasury) and the Organization for Economic Cooperation and Development (OECD) permit a company to select from a number of transfer pricing methods for its intercompany transfers. Companies select their transfer pricing methods from among these enumerated methods, often selecting different methods under different circumstances.

In contrast, companies engaged in production and sale of goods almost invariably use only one method, a cost-based system, for intracompany transfer pricing purposes. Most often, these companies utilize full standard cost transfers or full actual cost transfers, and do so without a profit add-on. Without the constraints imposed by the taxing authorities, many companies decide upon an arbitrary intracompany pricing policy that departs from the norms of intercompany transfer pricing tax policy in a number of respects.

Many companies have two pricing regimes: the company employs transfer pricing methods for intracompany transfer pricing purposes and then employs different transfer pricing methods for intercompany transfer pricing purposes. Practical problems then arise as to the coordination of these transfer pricing methods and the availability of the documentation in the context of the transfer pricing penalty contemporaneous documentation rules. The Internal Revenue Service (IRS) may be able to use intracompany information against the taxpayer.

In a number of situations, the goods produced and transferred may be intermediate goods or work-in-process rather than final goods. Intermediate goods by their very nature have no market price, because these goods are not yet marketable. The transfer pricing problem is to measure the cost of production for these intermediate goods.

(b) Selecting a Pricing Strategy

A business that is engaged in the process of selecting one or more transfer pricing methods should consider a number of external variables in selecting such a method, whether this decision applies to intercompany transactions or to intracompany transactions. Following are ten of the most important external variables that affect the selection of a transfer pricing method:

1. U. S. income tax considerations
2. State income and property tax considerations
3. Taxation imposed by a foreign entity
4. Market position, including oligopoly or oligopsony
5. Customs duties and enforcement
6. Inflation or deflation
7. Production capacity, including the efficiency of the plant
8. Currency fluctuation and hedging costs
9. Currency control mechanisms and their effectiveness
10. Relationships with the above mentioned governments

The relative importance of each of these external variables varies between one business and another. Weighing these factors a priori would be counterproductive. Moreover, a business should change the list of variables or the priorities within these variables over time as conditions change.

A. 2 DIVISION AND PROFIT CENTER ACCOUNTING

Before we can address intracompany transfer pricing issues that may be applicable to a particular business, it is important for us to understand the basics of nomenclature and terminology for such concepts as "divisional accounting," "cost center," and "profit center" in the transfer pricing context. For purposes of this analysis, a division is an operating unit that is a principal portion of a corporation in which managers have decision-making authority. A profit center could be a division of a business, but divisions often encompass many profit centers. Cost centers rarely reach the level of constituting divisions. The division or operating unit may encompass more than one legal entity, an issue that the author acknowledges but does not specifically address, in this analysis.

(a) Cost Centers and Profit Centers

A division or other segment of a business could be either a "cost center" or a "profit center." Let us introduce these two concepts.

A cost center accumulates costs. Top corporate management normally evaluates a division that is a cost center by focusing on the efficiency of the operation only, such as a reduction in the cost of materials, labor cost savings, operating efficiencies, or other cost saving. Pricing decisions are outside this division's responsibility.

A profit center accumulates profit or losses in the accounting sense. In essence, the division is viewed as a mini-corporation. A profit center is more likely to be autonomous, making its own intercompany pricing decisions and pricing policies to outside third parties, but this is not always the case.

(b) Divisions Within the Company

As a starting point in addressing divisional transfer pricing, consider a company that operates as two divisions, a manufacturing or production division and a selling division. The pricing alternatives are complex, even in this simple situation, as indicated by the following alternatives:

1. Autonomous transactions
The production division determines the intracompany price on its own for the goods that it produces; the selling division determines the intracompany price on its own for the goods that it acquires.

2. Mandated transactions
The intracompany price is determined by both the production division and the selling division acting together. The intracompany price is determined by the corporation rather than by its divisions.

A. 3 AUTONOMOUS TRANSACTIONS

Following is an examination of the roles of the manufacturing or production division and the selling division from the standpoint of intracompany pricing and the application of autonomous transactions.

(a) Operations of the Production Division and the Selling Division

The production division could be a profit center or merely a cost center. A cost center production division has no authority over intracompany prices, while a profit center production division might have this authority over intracompany prices. At the outset, a production division that does have the authority over intracompany prices would be tempted to maximize its intracompany price, with a goal of maximizing net income for its own division. Then, bonuses and profit sharing for the production division should follow from the divisional results, assuming the corporation evaluates results based on bottom line net income.

Similarly, a selling division could be a profit center or merely a cost center. A selling division that has authority to determine intercompany prices would be tempted to minimize its intercompany price, with a goal of maximizing net income from its division. Bonuses and profit sharing would then presumably follow from the divisional results, assuming the corporation evaluates results based on bottom line net income.

Divisional autonomy is favored by managers in many situations because it gives the manager authority that is similar to that of corporate management. The corporation could more realistically base performance and rewards of the division on financial outcomes. The manager's authority is equal to the financial responsibility. The autonomous divisional manager may have authority over capital investment decisions, output levels, and pricing of the final good, as well as intercompany pricing. Nevertheless, the transfer pricing regulations conspicuously ignore the possibility that autonomy could occur. Intercompany transfers take place as if they were at market when the division has autonomous decision-making authority.

Autonomy enables a division to purchase or sell to third parties, which can be affected by excess capacity or by spare plant capacity. Because the divisions are not required to trade with each other, internal transfers, if they occur, tend to be smaller in volume.

(b) Autonomy and Authority

Autonomy between divisions gives each profit center the authority to set prices for itself and other divisions. Divisional autonomy is successful if the following situation applies:

1. The production division has the authority to sell its products to outside parties rather than only to the selling division, and

2. The selling division has the authority to purchase its products from outside parties rather than only from the production division.

Providing a division with full authority over intercompany pricing is not viable unless the above-mentioned conditions apply. In this scenario, each profit center is a distinct business, having a pricing strategy that is independent of the pricing strategy of the other profit center. Each division determines whether to engage in transactions with internal sources (the other division within the group) or with external sources (third parties). These transactions are not mandated. In essence, the ability to sell or purchase products from the outside market serves as a "safety value."

When working as a university professor in economics in the Soviet Union during Communist times, this author observed that the lack of divisional autonomy among businesses could lead to market collapse. Many corporate structures in the United States and elsewhere do not permit divisional autonomy, as a facet of the market mechanism, to work correctly. Instead, corporate leaders dictate transfer pricing. On the other hand, the market mechanism does not readily apply to intercompany transfers because comparables and competition often do not exist.

Phrased differently, exchange autonomy is viable if there are comparables, necessitating that the comparable uncontrolled price (CUP) method must be viable, whether or not it is the best method. For example, the autonomous divisional structure would apply to a canner of foodstuffs in which the growing division is autonomous from the canning and selling division. The growing division could sell the foodstuffs elsewhere if the canning and selling division establishes its price that is below the market price. The canning and selling division could buy the foodstuffs elsewhere if the growing division establishes its price that is above the market price. The presence of autonomous transactions tends to mandate against unitary transaction treatment for state tax purposes, which can be advantageous or disadvantageous, depending upon the circumstances of the business.

(d) Objections to Divisional Autonomy

Autonomy among profit center divisions poses the danger that a profit center could optimize its own results at the expense of corporate goals, such as a selling division that acquires good externally when there is excess capacity in the production division. Autonomy would not be satisfactory in situations in which unique parts are produced or sold, or where intangibles are a significant factor. The presence or absence of divisional autonomy should be an indicia of the CUP method, but it is not recognized as such in the current Treasury transfer pricing regulations.

A company that is in unrelated businesses must depend on financial results of each division, which are beyond the control of any individual division under review. However, in such a situation there are few intercompany transfers. Moreover, higher level managers cannot be very familiar with the details of these diverse businesses, and instead emphasize measuring, evaluating, and rewarding divisional performance. Autonomy does not work well when product design and development are an important facet of the business, such as a business in the growth phase of its lifecycle, because the selling division should be able to affect product design and development.

A. 4 VERTICAL INTEGRATION AND MANDATED TRANSACTIONS

A corporation's management could postulate that the production process and the sales process together would lead to efficiencies and other economic benefits. Such a company is likely to mandate the price for internal transactions. Mandated transactions are more likely to create unitary taxation for state tax purposes, which can be advantageous or disadvantageous, depending on the company's circumstances.

Corporate headquarters using the mandated approach to determine transfer pricing can unilaterally determine prices between divisions. Mandated pricing had been applied in other situations, in the Soviet Union for example. Most corporations that mandate transfers determine the intercompany price based on full cost, whether they are full cost transfers or actual cost transfers, but some companies permit marginal costing. In contrast, intercompany pricing between divisions in the Soviet Union was often arbitrary, and the Russian accounting system did not reflect marginal costing.

The vertical integration approach views a division as a profit center only for external third-party sales, if they occur. Mandating full cost transfers between the manufacturing division and the selling division based on full cost transfers treats the manufacturing division almost as a cost center rather than as a profit center. This mandated full cost transfer approach tends to emphasize the importance of the sales division in contrast to the manufacturing division. The unit that receives the product at full cost from the manufacturing division retains all the profits or losses on external sales of the final goods.

The selling profit center could be viewed as a distinct profit center for both internal sales and external sales. In that event, corporate management could mandate that transfers are at market, providing profit or loss to the manufacturer and to the seller. Mandated market-based transfers are analogous to autonomy in many respects. Each unit is held responsible for all profits and losses when it transfers the goods at market, as if it sold the entire output externally.

A. 5 MANDATED SALES VERSUS AUTONOMOUS SALES

A number of transfer pricing issues remain after the decision between autonomous pricing and mandated pricing is made. Chief among these issues are the following:

1. cost accounting for unused capacity, and
2. accounting for product design and development.

(a) Cost Accounting for Unused Capacity

The selling division that is autonomous, having full profit and loss responsibility, is entitled to purchase goods externally, even though spare capacity exists internally. The production division that is autonomous, having full profit and loss responsibility, is entitled to sell the goods externally, even though spare capacity exists internally. The same situation may apply to a division that is subject to mandated full costing pricing rules, but has the authority to buy or sell independently. Potential sales of intercompany transactions may be lost to unrelated manufacturers in these situations.

A cost-based transfer pricing approach causes difficulties for businesses that have unused capacity and other sunk costs. The initial culprit is the full costing rules themselves that require total costs to be spread among fewer units when the plant is not fully utilized. The ultimate culprit may be the Treasury rules, which require full costing and uniform capitalization and restrict the use of the practical capacity method. 1 The capacity issue is most severe when capacity utilization is less for the manufacturing division than it is for competitive manufacturers. The manufacturing division must then allocate a portion of the unused fixed capacity costs into profit structure that will make the product uncompetitive.

(b) Product Design and Development

The selling division and the manufacturing division might not have coordinated product design and development in an appropriate manner, and might not have an occasion to coordinate with each other, when the divisions are autonomous. The selling division might be working with outside suppliers for the product design and the development of new items or components. The manufacturing division or other internal suppliers may be outside the "loop" and fail to develop the skills or technology to produce the new items or components, causing a loss of business.

A. 6 ADMINISTRATIVE ASPECTS OF TRANSFER PRICING

The administration process of determining a company's transfer pricing practice is affected by factors such as the following twelve:

1. Corporate goals and strategies
2. Divisional control, whether autonomous or mandated
3. Authority over transfer pricing: general managers, financial managers, and other executives in the decision-making process
4. Management style and conflict resolution
5. Corporate culture
6. Information utilized for the transfer pricing decision
7. Frequency of transfer pricing change
8. Technology and innovation of the product
9. Market characteristics of the product
10. General business conditions
11. The accounting system
12. The cost accounting system

Following is a discussion of five factors: the range of transfer pricing activities, the scope of management activities, the information utilized, timing, and management style and conflict resolution.

(a) Range of Transfer Pricing Activities

Activities to establish the intercompany transfer price can range from "mandated rules," set up by top management, on the one hand, to "pure negotiation" on the other hand. Mandated pricing rules, as so determined for intracompany pricing, could be similar to the following examples:

1. Fully allocated cost plus 20 percent
2. Resale cost less 15 percent, or
3. The closing price for the commodity quoted in the financial press during the preceding day, less two basis points.

(b) Scope of Management Activities

Transfer pricing could be determined by a number of executives in various capacities, including the following, for example:

1. corporate-level managers
2. financial managers
3. managers in the selling division
4. managers in the selling division and the production division
5. a combination of any of these.

(c) Information Utilized

Managers can rely upon a number of types of information in setting transfer pricing, including the following:

1. corporate records
2. division records
3. cost data
4. market data
5. comparative data

(d) Timing

Timing could affect the frequency and timing of transfer pricing adjustments, such as the following:

1. periodic (daily, weekly, monthly, quarterly, or annually)
2. episodic (based on other events, such as comparative market conditions, cost changes, currency changes, changes in the borrowing rate, or the like).

(e) Conflict Resolution

Transfer pricing conflicts are inevitable because divisions of a business have different transfer pricing strategies. Businesses that recognize that these conflicts will occur may seek to minimize these conflicts, while still recognizing that conflict resolution is part of the process by which pricing is determined. Conflict resolution could include the following:

1. by force
2. by conciliation
3. by bargaining

A number of businesses, as well as what was the Soviet Union itself, have resolved pricing disputed by force. In a bygone era, this approach was viewed as "father knows best." The concept underlying this dictatorial approach is that the leaders have access to information that is unavailable to others farther down the chain. The users of that approach would argue that the information is difficult to convey and hard to apply, and would be duplicative. They would argue that the leaders, whether by birthright, education, or otherwise, are better able to dictate these decisions.

Some businesses attempt to resolve divisional pricing disputes by conciliation, perhaps even having a mediator within the corporation that could resolve these disputes. However, the mediation process itself is cumbersome. Businesses that use this process limit this approach by limiting the device to an infrequent period, such as once a year, and limiting the process to major divisions within the business.

Other businesses attempt to resolve divisional pricing disputes by bargaining. Businesses that apply this approach would argue that this process most fairly approximates a true market price. On the other hand, use of a bargaining approach is cumbersome in its own right and should be limited in a manner similar to that of the conciliation approach.

Many businesses employ a mixture of the three conflict resolution techniques. Conciliation is suggested as the preferred method, but it is rarely applied and is used only when major events occur. Most conflicts are decided by force.

A. 7 CORPORATE AND DIVISIONAL VANTAGE POINTS

Divisions of a business have a different point of view than the corporation as a whole when it comes to transfer pricing. There is no easy example as to which approach is best, as the following examples illustrate. The following examples illustrate the fact that grouping of transactions is beneficial in some cases but not in others.

(a) Basic Example

Assume, in this fact pattern for both examples, that the business has two divisions, Manufacturing Division X, which produces the initial product, and Manufacturing Division Y, which completes the product. The production work done by Manufacturing Division X can be used in Manufacturing Division Y if the situation warrants. Division X can sell the incomplete products to third parties; alternatively, Division Y can sell the completed products to third parties.

(b) Example One: Grouping of Transactions Is Beneficial

Assume that Manufacturing Division X produces Product A, with a standard variable cost of $6 per unit. Manufacturing Division X has a choice in this example, either to sell Product A to outside customers for $9 or transfer Product A for $6 to Manufacturing Division Y. Division X could break even by making the intracompany sales to Division Y or could earn a profit of $3 per unit by making external sales. In the normal course of events, Division X would prefer to make the external sales.

Manufacturing Division Y could purchase Product A for $6 from Manufacturing Division X, process Product A at a standard variable cost of $5, and sell Product A to unrelated parties for $16. Division Y would make a profit of $5 (sales price of $16, less transfer price of $6, less variable cost of $5). The sale of Product A by Manufacturing Division X to a third party would prevent Division Y from gaining income from this product.

In this scenario, Division X would prefer to sell Product A to the outside world rather than transferring the product to Division Y. Division Y would prefer to have the opportunity to contribute, and the company as a whole would benefit from the interaction of Division X and Division Y. The better course would be to mandate the transfer between Division X and Division Y at a division price of $9. In that event, Division X would earn $3 and Division Y would earn $2.

Beneficial Aggregation

Assume, in this fact pattern for Example 2, that the business has two divisions, Manufacturing Division X and Manufacturing Division Y. The production from Manufacturing Division X can be used in Manufacturing Division Y if the situation warrants. Assume further that Manufacturing Division X produces Product A, with a standard variable cost of $6 per unit. Manufacturing Division X can either sell Product Ato outside customers for $12 or transfer Product Ato Manufacturing Division Y for $6. Division X would break even by making intracompany sales and would earn a profit of $6 per unit through external sales.

In this scenario, Division X and Division Y standing together would have income of $5 (sales price of $16 less standard costs of $6 in Division X less standard variable costs of $5 in Division Y). However, a direct sale by unrelated purchasers would increase the entire income to $6. In essence, Division Y had negative income of $1, reflecting the market price of Product A rather than the cost of Product A.

Detrimental Aggregation

Under the above approach, Division Y does not participate and is not entitled to any portion of the income. All of the profit is attributable to Division X.

(d) Cost-Basis Approach-Equal Contribution Margin

The evaluation of divisions and divisional profitability may rely on a sharing of the total contribution margin among these divisions. This contribution margin can be divided between the production division and the selling division, or between the two production divisions. The contribution margin can be allocated pro rata on the basis of variable cost.

Consider the following example: Business Y has two divisions, Division A and Division B. Division A sells all of its products to Division B. Division B sells the goods to the open market for $30. The variable costs are $6 for Division A and $4 for Division B, or $10 in total. The profit margin or operating income (revenues less variable costs) is $20 in total ($ 30 minus $10). The company could use a cost-base apportionment, treating the operating income or the profit margin of each division as proportionate (that is, equal as a percentage of cost), thereby apportioning $12 to Division A and $8 to Division B.

Tax authorities may not necessarily approve the cost-basis apportionment and equal contribution margin approach. Divisions may have unequal risks or functions that would preclude equal treatment for variable costs. Note that this ratio is similar to that advocated by Dr. Berry.

(e) Profitability Apportionment

Businesses can apportion profitability on the following basis:

1. variable costs
2. standard costs
3. by negotiation

Businesses may permit divisions to negotiate the allocation of the profit margin. Regrettably, this negotiation process may be time-consuming, may lead to conflicts, and may be sub-optimal from the standpoint of the entire company. Moreover, this negotiation process favors executives with negotiation skills rather than executives who can produce goods efficiently.

The negotiated approach is not necessarily advantageous. It is easier to convert a cost center to a profit center if the contribution margin is not negotiated. This transfer pricing approach is consistent with management decentralization through the use of profit centers. As such, the motivational advantages may be retained by use of a variable cost apportionment process.

Converting cost centers into profit centers through the use of an apportioned contributed margin technique may encourage cooperation between divisions. Divisions are encouraged to act together because the ultimate profit of each division depends upon the contribution margin received by the company as a whole. All divisions will benefit from the cost efficiency that each division achieves. Each division then retains the motivational advantages of having a profit center as it complements the profit orientation as to third-party transactions. Both divisions together act as a profit center.

Apportionment of income among divisions may encourage cooperation. Moreover, this apportionment process can encourage competition among divisions that are similarly situated. Consider a situation in which Division A manufactures Product X and Divisions B, C, and D assemble Product X. Divisions B, C, and D perform the same functions and have similar assets and risks; intracompany transportation charges are similar for each division. Overall profitability can be maximized when Division A connects with the assembly division that is most efficient, a goal that would be sought by the business as a whole. Thus, each division would be concerned about the others' cost of performance and level of production or sales.

(f) Pro Rata Sharing of the Benefits of Cost Reduction

The apportionment of variable income among divisions may lead to cooperation between the divisions, but this transfer pricing strategy has one negative side effect. Adivision that reduces its costs is not entitled to the entire benefit and must share this benefit with other divisions. The saving that a division retains is then proportionate to the split of the contribution margin.

Consider the following cost reduction example: Assume that, in the preceding example, Division A reduces its variable costs from $6 to $4. Total variable costs for Division A and Division B then are $8 ($ 4 from Division A and $4 from Division B). The profit margin or operating income would then be $22, reflecting revenues of $30 and variable costs of $8. Operating income would then be $11 for each division.

Division A had caused variable costs to decrease by $2, which increased operating income or net margin by $2. The application of cost-based apportionment for operating income reduces Division A's operating income by $1 (from $12 to $11) because of the cost savings that Division A engendered, a clear disincentive for cost savings. Division B's operating income would increase by $3 (from $8 to $11) as a result of division A's $2 cost saving.

(g) The Constant Ratio Apportionment Method

The constant ratio apportionment method (apportionment determined before the cost reduction) might be viewed as less distortive. The original variable cost between Division A and Division B was 60 percent and 40 percent, respectively. The $2 cost reduction increased the profit margin from $20 to $22. This apportionment method would be retained and applied to the profit margin, which then becomes $13.2 (60 percent of $22) and $8.8 (40 percent of $22), respectively. This division of profits would be reflected as follows:

The above approach enables both divisions to share the benefits from the cost savings. Division A and Division B share the savings proportionate to the original split of the contribution margin.

(h) Entire Benefit Approach

The third approach is to give the entire benefit to the Division that earned the benefit, in this case to Division A, for reducing costs from $6 to $4. Division A's revenue is unchanged at $18, but income increases from $12 to $14.

(i) Summary of the Results

The results of these apportionment methods can be summarized as follows:

Some companies consider the entire benefit method to be the most accurate under the rationale that the division that created the benefit earns the benefit. Other companies recognize that both divisions must work together to achieve the benefit for all. These companies use the constant ratio approach.

A. 8 DETERMINING THE NUMBER OF PROFIT CENTERS

A company may be tempted to have many profit centers, dividing existing profit centers when needed. This approach is said to lead to the following benefits:

1. More profit centers lead to more management opportunities, especially for general managers and general managers to be.

2. The presence of more profit centers facilitates more diversity of product lines.

Each manufacturing profit center must be self-sufficient from a production capacity standpoint. Economies of scale should apply, so that multiple plants making the same product should be as efficient as one large plant. This multiple profit center technique may lead to a high level of independence among profit centers, reflected in substantial transfers between profit centers.

A. 9 BY-PRODUCTS AND JOINT PRODUCTS

The characterization of products as either by-products or joint products is an important issue that the transfer pricing regulations have not addressed. This issue is most relevant in situations in which a cost method, such as the cost plus method, could be applicable. The joint product approach divides the costs incurred by some rational method, such as weight of the products, volume, or another criterion. The by-product method does not treat the subsidiary products as products per se, but treats the revenue from these subsidiary products as an offset to the production costs of the underlying principal product.

The joint product/ by-product issue applies to many petroleum products, chemicals, and agribusiness products. Consider the following agribusiness examples:

1. A rendering facility converts fat and bones into tallow and meal. A question arises as to whether meal is a by-product or a joint product. Allocation of the production cost based on weight may create losses for meal and profits for tallow sales. The by-product method, by offsetting the meal revenues, may reduce tallow income. This issue is important for foreign tax credit and (FSC) purposes because tallow is likely to be exported, but meal is rarely exported.

2. Peanuts can be sold shelled or unshelled. A question arises as to the treatment of the shelling process. After shelling, the shells could be used for feed or for construction material. A question arises about whether the shells could be viewed as a joint product or whether the shells are a by-product. The latter approach would reflect the sale of the shells in determining the cost of peanuts.

3. The ginning process results in cotton and seeds. The seeds have a use, as the seeds themselves are used to produce cottonseed oil, which is often used as in food products or as cooking oil. Aquestion arises about whether the seeds are a joint product or a by-product and whether the hulls are a by-product or a joint product.

4. Cattle are slaughtered into commercial-grade products, such as steak, and other products such as liver, tongue, heart, and offal products. The latter category of goods may be sold overseas, perhaps creating foreign tax credit or FSC benefits. A question arises about whether these products could be treated as by-products, enabling these products to be taken into account without any allocation of cost.

A. 10 COSTING ALTERNATIVES

A profit center is most likely to transfer products to another profit center using one of the following methods:

1. at actual full cost,
2. at standard full cost, or
3. at market-based transfer price.

A company tends to apply one of the full cost transfer techniques when the company has an aggregate combined profit center and has multiple divisions that are profit centers.

A. 11 APPLYING MANDATED FULL COST TRANSFER PRICING

Transfer prices can be set in one of two ways under the mandated full cost transfer method:

1. Actual manufacturing division costs to make the product
2. The manufacturing division cost under a set of assumptions--i. e. standard costs to make the product

The standard cost system compares standard costs to actual costs. The difference between these amounts, termed variances, includes raw material variances, labor variances, and other variances. The business must determine which division has the responsibility for each variance. The standard cost system seeks to compare the following items at the volume of units produced:

1. Actual costs at the cost center
2. Standard costs at the cost center

Standard costs should take all production costs into account, including, for example, assumptions about volume, production efficiencies, and access to raw materials. Actual costs are subtracted from standard costs and this difference is viewed as a variance. Positive variances occur when actual costs are lower than standard costs; implicitly, management has succeeded in some manner to create a positive variance. Negative variances occur when actual costs are higher than standard costs; implicitly, management has failed in some manner to create a negative variance.

The concept of "mandated full cost transfers" indicates that the transfer price is determined by the corporation in advance. A division must abrogate its own authority over prices. The division must give priority to internal demand rather than benefit from third-party sales. Mandated full cost transfers restrict other divisions' authority as well, because it prevents other divisions from sourcing the goods externally. Asecond division may prefer to buy from other sources because of quality, cost, or timing. Mandated full cost transfers reduce profit responsibility to the divisions, especially as profit centers, to the extent that the profits from intermediate goods are reduced to accommodate divisional sales.

A. 12 FULL STANDARD COST TRANSFER PRICES

Using full standard cost to transfer goods from division to division lessens the extent to which the performance of one profit center affects the performance of other profit centers. Standard costs are set in advance, and are known before the transfer begin. Both divisions know the transfer price before the exchange takes place. Such is not the case for full actual cost transfer pricing. The performance of a division that transfers goods at full standard cost is not affected by conditions that are beyond its control. Standard cost transfers are performance measures that reflect divisional responsibility that is commensurate with managerial authority. Transfers of goods at standard cost more clearly pinpoint financial responsibility than do transfers of goods at actual cost.

The presence of a procedure that transfers goods at actual cost signifies that the financial performance of each division engaging in the transfer is related to other divisions. Standard cost transfers diminish this interdependence, but provide more meaningful results.

A. 13 BEHIND THE STANDARD COST SYSTEM

(a) Issues in Applying Standard Cost Systems

Standard cost systems are open to a number of vagaries, including the following:

1. Assumptions
2. Results of engineering studies
3. Estimates of future costs
4. Information utilized
5. Control systems

When applying a standard cost system, a company should take into account a number of components, including cost and availability of raw materials, labor contracts and other labor issues, energy consumption and consequences of deregulation, advances in technology, and the like.

(b) Timing of Modifications

The standard cost system must change over time to reflect new facts. A standard cost system that remains static leads to a proliferation of variances that may become unwieldy. Ultimately, such a standard cost system loses credibility. On the other hand, frequent changes in the standard cost system mean that the "standards" are not standard. Standard costs are often computed on an annual basis, but take into account adjustments for raw material. Companies use criteria such as the following to change their standard costs:

1. on an as-needed basis
2. on a monthly basis
3. on a quarterly basis
4. annually
5. under different criteria

Profit centers have an incentive to identify which variances they can control and which they cannot. The profit centers should receive positive variances and negative variances depending on whether the events are under their control. "Control," in this case, may be quite limited, and can be affected by currency fluctuations, fluctuations in material costs, and business conditions. Disputes concerning variances are likely to occur even if all profit centers accept full cost transfer pricing policy. After all, these variances affect measures of cost and profitability for measuring, evaluating, and rewarding performance.

A profit center can separate three types of variances based on responsibility:

1. volume
2. efficiency
3. purchasing

The above variances are most often viewed as attributable to the production division, not to the selling division, except for external sales. However, assignment of responsibility is difficult. For example, interruptions can be created by selling division requests that interfere in production runs. These variances should be attributed to the selling division.

Variances are a measure of performance for the profit center, giving the profit center incentives to excel. Performance measures should pertain to desired goals, whether that is current income, an accretion in wealth, or return on assets. The measurement process that would establish standard costs gives the appearance of being scientific, but the process itself is often subjective, especially in the transfer pricing context.

A. 14 MANDATED MARKET-BASED TRANSFER PRICING

Mandated transfer pricing policies can be significantly different from mandated full cost. A company could attempt to use third-party pricing to determine its intracompany market-based transfer price. This process tends to be complex at the divisional level, just as it is for intercompany transfers. Transfer pricing issues arise in two specific situations:

1. The volume of intercompany sales is extremely large compared with third-party sales.
2. Internally transferred products differ from products sold externally.

(a) Using External Sales to Determine Intracompany Sales

Application of external sales data to determine the transfer price for intracompany sales faces a number of obstacles:

1. The production division may be a large producer of the goods, both in absolute terms and as a percentage of the relevant market, limiting the ability of the production division to secure comparable sales, aside from sales to the selling division. In addition, oligopolistic considerations may cause the production division to deviate from any true market price.

2. The selling division may be a large purchaser of the goods, both in absolute terms and as a percentage of the relevant market, limiting the ability of the selling division to secure comparable purchases, aside from purchases from the purchasing division. In addition, oligoponistic considerations may cause the selling division to deviate from any true market price.

3. The production division may be a large producer of the goods at the same time that the selling division may be a large purchaser of the goods, both in absolute terms and as a percentage of the relevant market. Comparables are unlikely in this situation because either or both divisions are likely to achieve sufficient economies of scale.

4. External data may itself be distortive in a number of circumstances, including the following:
A. The seller may be undertaking oligopolistic practices.
B. The purchaser may be undertaking oligopsonistic practices.
C. A supplier may have excess capacity, and may reduce prices to increase the utilization of the capacity.
D. A supplier may attempt to make use of "special circumstances" such as marginal costing. Afterward, that supplier may increase prices.
E. The supplier may be uninformed about the market as a whole or the costs of production or distribution.
F. The product may be sold in a different form, for example, in less-finished form, when sold to other divisions.
G. The product may have different specifications for external sales than for divisional sales.

The production cost center and the selling cost center may view supplier relationships and customer relationships differently. Supplier relationships are important to the production cost center as to the quality of the materials, reliability of delivery, the determination of accounts payable and the collection, as well as cost. Supplier relationships may affect the selling cost center directly only to the extent of the cost of the items acquired by the production cost center. Customer relationships are important to the selling cost center regarding continuity of the relationship, determination of accounts receivable and payment, and other factors. Customer relationships may affect the production cost center only to the extent of the effects on the immediate sale.

(b) Making Changes to the Intracompany Transfer Price

The decision to change intracompany transfer prices differs between companies. Some businesses change their intracompany transfer prices on a current basis; others change their intracompany transfer prices only infrequently, even if the business utilizes market-based transfer pricing. Factors influencing this decision should include:

1. The magnitude of the changes in cost, whether direct labor, outside vendors, raw materials, and the like.

2. The change in external prices.

3. Administrative difficulties in changing intracompany transfer pricing.

There is a relationship between intracompany transfer pricing (and intercompany transfer pricing) and the price to third parties. Consider the following situations:

1. The company may impose minimum margins on the sale of final goods to third parties. The selling division might choose to forego that business if its margins are below that threshold, even if this business would be profitable for the company as a whole. Alternatively, the selling division may keep its margins high to meet these threshold requirements, but in so doing the company may attract competition.

2. Neither the production division nor the selling division may have long-term responsibility for the product. Neither division will maintain the competitive strength of the final product, to do what has to be done to keep the product viable over the long term. The business suffers from lack of research and development (R& D) on a long-term basis, but the benefit is short-term savings.

A. 15 COST PLUS MARKUPS

Most companies transfer goods from one division to another without any "plus" or other markup. A few companies use a plus if they can tie the plus to third-party sales, but this situation is infrequent. Other companies add overhead and profit, but often little thought has been given to ascertaining the plus. Following are some of the approaches utilized for intracompany transfer pricing, related to cost plus markups:

1. The company anticipates the profit from both divisions as a whole and weighs the contributions of each. This analysis leads to a contribution margin for the production division. This approach is complex, and is infrequently applied, except to major product lines.

2. The markup is based on a constant rate of return for the product line.

3. The average profit center becomes the markup for the center.

4. A standard gross margin is used for the profit center.

5. A company uses an arbitrary margin, such as "cost plus 10 percent." In many situations, no thought has been given to ascertaining the magnitude of the "plus" nor even to the rationale behind the "plus."

Conflicts can arise because of cost plus pricing. The production profit center will most likely become aware of costs of the selling profit center and the selling profit center will become aware of the costs of the production profit center. Both parties will have sufficient information to dispute the magnitude of the markup, even if the company has a goal of achieving a "fair" profit for each. These disputes often can be resolved by comparing proportional contributions of the divisions. Market-based transfer pricing does not lead to such a full analysis, because this data is not likely to be made available to each party.

A. 16 APPLYING THE RESALE METHOD TO INTRACOMPANY TRANSFERS

Some companies use a resale method to determine the intracompany markup. The selling division solicits competitive bids from external suppliers for comparable final products. The markup from the production division to the selling division is determined by subtracting internal selling costs from the external suppliers' bids.

A company seeking such a bid may face certain risks. In providing bidders with sufficient information to make a bid, it may be giving the bidders sufficient information to go into competition. The intracompany transfer price is often a markup on costs, whether these costs are actual costs or are standard costs. The markup should reflect economies of scale, such as the benefits from increased volume resulting from fixed costs being spread among more units. Instead, many companies determine their intracompany pricing by relying only on variable costs.

The production profit center has no incentive to reduce costs if the production profit center is entitled to a standard percentage markup. In fact, the production profit center will increase its income by being less efficient. Under this pricing formula, profits of the production division will increase as the base, i. e., costs, increases proportionally. Businesses would be better off by requiring a constant markup, i. e. cost plus fixed fee, a pricing device often used for federal contracts. Both the production cost center and the selling cost center should coordinate and cooperate in designing proprietary technology. Both cost centers should work together to discuss design requirements and other long terms issues.

A. 17 CONCLUSION

Intracompany transfer pricing involves many of the same issues as does intercompany transfer pricing, most often without the input of the relevant tax collectors. However, solutions to these issues differ between intracompany transfer pricing and intercompany pricing. Expediency tends to be more important because the volume of transactions tends to be larger and the size of the transactions tends to be smaller.