Abstract
Transfer pricing has become an essential tool for tax authorities, managers, and all parties that are involved in the accounting profession. Nevertheless, different companies use diverse methods to determine their transfer prices, depending on the company structure and the specific strategy. However, transfer pricing does not apply to most domestic organizations. It is best suited for international organizations’ operations. In this particular regard, the paper seeks to evaluate the benefits and applicability of transfer pricing from both an organizational and industrial perspective. It will analyze the impact of the method on a firm’s profits, performance evaluation, and decision-making. The paper also applies the concept of a learning curve to transfer pricing to aid in estimating the associated labor time and costs.
Introduction
Definition
According to The Department of Economic & Social Affairs (2013), transfer pricing is defined as the pricing of goods and services that are to be transacted between two legal entities within an enterprise. For instance, a subordinate business can trade commodities to a parent corporation (The Department of Economic & Social Affairs, 2013). The cost incurred by the parent company is referred to as the transfer price. Therefore, the transfer price can be referred to as the price at which organizations’ units transact business. To understand the concept better, the next section discusses the theory of transfer pricing.
Theory of Transfer Pricing
According to Shunko, Debo, and Gavirneni (2014), the reason for using transfer prices between separate business divisions within an enterprise is to ensure that each unit is independent in terms of profitability, accounting, and taxation. Many businesses have established triumphant promotion and manufacturing tactics around the learning curve. It is crucial to point out the link between the learning curve and transfer pricing. The learning curve is a straightforward but influential theory that explains how commodity costs go down steadily by a universal percentage whenever the amount (of commodities) doubles.
The learning-curve correlation is significant in transfer price forecasting since raising a business’ commodity quantity and market share has the potential of leading to cost benefits over the rivalry. Moreover, negotiated transfer pricing also enables managers to estimate the hidden cost of labor by applying the learning curve in their accounting to better plan for their respective divisions. Cost basis occurs when firms set the transfer price either at the full cost or at the variable rate that is incurred by the selling division. However, this form of transfer pricing model is linked to several demerits. First, the method faces the risk of sub-optimization and bad decision-making due to the hidden or unexpected labor costs and time.
As Shunko et al. (2014) confirm, some people consider market price basis the best approach. Also referred to as arm’s length pricing, it is applied in the event of a transaction between two unrelated divisions. In most countries, firms operate at the marginal cost where the cost of the variable for each additional unit will be lower than the cost of production. Under such a scenario, the market prices of the company will be reduced compared to the cost-based price. As a result, the foreign subsidiary will opt for a market-based fee.
However, market transfer pricing is less flexible when it comes to incorporating the learning curve because the market forces already determine the price of a particular good. Thus, little adjustments can be made to constitute labor cost estimates that are obtained using the learning curve relative to the market price. As the succeeding section reveals, many companies have benefited from the concept of transfer pricing.
Benefits of Transfer Pricing to an Organization
Tax Reductions and Profit Maximization
Consider an organization that has divisions in different countries, provinces, and states. According to Usmen (2012), differences in rates of jurisdiction such as tax rates are bound to influence enterprises’ transfer prices. One of the incentives of firms involves maximization of profits. One of the ways of achieving this goal is by letting businesses manipulate their transfer prices to allow them to locate their profits in countries or jurisdictions with low taxes. For example, by applying the learning curve to forecast its direct labor costs, an organization may opt to reduce the overall costs via producing assembly inputs in a low-tax country.
The inputs may be pulled together in a high-tax country. This business can benefit by increasing the value declared for the parts it sells to its division of assembly in the high-tax jurisdiction, thus allowing it to reduce its tax payments (Usmen, 2012). Ultimately, the organization will manage to increase its revenue and profit margins in its low-tax jurisdiction. Similarly, in the case of reversal of the tax environment of the country such as increased tax in a higher-rated country and lower tax in a lower-rated country, the company can reduce its burden of tax by reducing its transfer price (Usmen, 2012).
Decentralization of Management
Xiaoling, Shimin, Fei, and Yue (2015) reveal how the implementation of transfer pricing enables corporate decentralization regarding corporate operations through the allocation of profit centers to the organization. This plan is beneficial to the organization since it enables managers of the profit centers to have some degree of control of costs, revenue, and profits. For instance, by applying the learning curve theory to estimate or reduce labor costs, budget for their respective divisions set the wage rates, and/or manage their inventory, managers can make better decisions that maximize the profits of their respective divisions.
Autonomy in planning and control of the performance of the profit centers allows managers to exercise better coordination in the activities of the organization. The profit-centered approach also encourages managers in charge of the profit centers to follow on the latest news regarding changes in the market, price fluctuations, and other critical information relating to the market. Moreover, top managers can acquire updates of the market conditions from the middle managers. The cost-based approach is advantageous as presented in the next section.
Specific Advantages of the Cost-based Method
A cost-based method of transfer pricing also offers specific advantages to an organization (Usmen, 2012). The method is described as being simpler since the transfer price is obtained or arrived at based on the costs of production of the specific product that is being transacted. Besides simplicity, other benefits of this method include the coverage of all production costs and other operational costs incurred by the division, saving on time, elimination of manager-manager friction, and provision of time to eliminate emerging hiccups in management.
However, to maximize the benefits, this type of transfer pricing requires the consideration of the learning curve, price policy, market conditions, market participants’ behaviors, competitors, and sensitivity of price, which may complicate the process. As a case in point, by applying the learning curve, managers can forecast the expected costs of their respective divisions, which are then incorporated into the final price, thus averting problems associated with other methods such as market-based transfer pricing. The following part presents the industrial applicability of the concept of transfer pricing. Specifically, it reveals how Oil and Gas, banking, and pharmaceutical industries have implemented the concept.
Industrial Applicability of Transfer Pricing
Oil and Gas industry
The oil and gas industry is continuously involved in dynamic bargaining between the oil-endowed countries such as Kazakhstan and large multinational oil corporations such as Shell. Nevertheless, through repeated interactions, oil-producing nations can improve their respective outcomes through strategic interactions and dynamic bargaining, hence enabling their advancement along a learning curve. On the other hand, by applying the learning curve to their interactions, multinationals can also negotiate a favorable price with the multinationals such as Shell among others as a way of reducing their direct costs such as wage costs. The shell can then use the negotiated price as its transfer price to sell oil and gas to its other divisions that are located in various countries (Hosman, 2009).
Banking Industry
According to Cadamagnani, Harimohan, and Tangri (2015), most banks rely on the Funds Transfer Pricing method to develop their business and small-scale interest levels. The interest rates are often based on a learning curve that estimates the costs of sourcing funds that are used for transaction purposes. The transfer pricing mechanism is applied to account for the cost of funds that the banks face, interest rate, liquidity, and currency risks that are attached to lending and depositing parties. According to Cadamagnani et al. (2015), the process of transfer pricing is carried out by the treasury function of the banks.
In this case, the capital utility plays the role of a risk administration center for all industry lines that the financial institution is involved in. For instance, the treasury function is responsible for borrowing deposits that have been raised by deposit-taking divisions of the bank. It lends to loan-originating divisions. Many profit-making and retail financial bodies make diverse transfer outlays. Moreover, the transfer prices set by the financial bodies are also used by the treasury of the venture “to provide funds to lines of business to make different loan types and/or set their rates at which they will remunerate business lines to raise deposits” (Cadamagnani et al., 2015, p. 153).
Pharmaceutical Industry
According to Roberge (2010), pricing controls by the government in the pharmaceutical industry may influence the overall profit enjoyed by the local distribution enterprises. As a result, most of the local distribution enterprises have resorted to transferring pricing as an alternative to protecting themselves against risks of pricing controls. Pharmaceutical companies have also addressed the challenge of pricing controls by incorporating the learning curve to establish their flexible transfer pricing systems and robust end-to-end processes that accommodate the challenges of pricing regulatory requirements and multiple taxes (Roberge, 2010). Transfer pricing has been fruitful in many organizations. The following section confirms this claim.
Organizational Applicability of Transfer Pricing
As Cavusgil, Knight, and Riesenberger (2007) observe, transfer pricing works best for international organizations, rather than domestic ones. Multinational organizations rely on transfer pricing as a provision for increasing their efficiency in the allocation of resources in their respective divisions, mitigating risks involved in international taxations through controlling their prices, ensuring better allocation of profits and tax revenues among divisions in operational countries, and as a means of monitoring related transactions between divisions in the corporate enterprise. The common use of transfer pricing in international business often defines the main difference in transactions between domestic and international organizations (Cavusgil et al., 2007).
As Shunko et al. (2014) assert, multinational organizations often involve a larger number of transactions between divisions within the enterprise than domestic organizations. Intercompany transactions provide multinational corporations an opportunity to adjust their income between different jurisdictions. Shifting of income from jurisdiction to jurisdiction is usually precipitated by aspects alluring to taxes such as differences in taxes between different jurisdictions of operations by the firm or by company-specific tax elements such as levy losses. However, many countries have incorporated measures that discourage multinationals from avoiding tax obligations by preventing them from adjusting their transfer prices.
To integrate the activities of different divisions, Cavusgil et al. (2007) show how multinational firms use the learning curve to estimate and determine their transfer pricing strategy as a means to maintain an ideal tradeoff between profitability and liquidity in the firms’ various divisions that operate under a range of jurisdictions. Moreover, transfer pricing is undertaken to maximize the company’s overall global profit. In some cases, a company can be structured in a manner that it operates different production stages of a single product in different countries. Thus, in such a case, integration using transfer pricing during interdivisional transactions may be required as a means of optimizing and strengthening the firm’s vertical linkages by ensuring that profit maximization is maintained in each division (Cavusgil et al., 2007).
Peters, Duchesne, and Slobari (2010) affirm that domestic transfer pricing is not widely used compared to its extended applicability by international organizations. International enterprises require more centralized planning and control compared to domestic firms. In addition, multinationals are exposed to varying tariff and tax regulations due to their running operations in different jurisdictions. Thus, transfer pricing is used as a means of mitigating the tax duties of a firm through the reduction of operational risks and the circumvention of tax limitations that have been imposed by different countries. Top managements of parent companies have access to more information in comparison with managers in charge of respective firms’ divisions.
Hence, such information would be more favorable in making management decisions. In this respect, international companies have a better method of determining their transfer prices than local/domestic firms. Such international companies have a more centralized management approach (Xiaoling et al., 2015). Although some domestic organizations apply the learning curve to determine their transfer prices, transfer pricing is best applicable for international organizations that have divisions spread across different parts of the world. Although the above sections have discussed the industrial and organizational applicability of the concept, it is crucial to offer examples of specific companies that have benefited from the implementation of the concept of transfer pricing.
Examples of Organizations and Industries Using Transfer Pricing
Organizations
As Tax Insights (2015) confirms, the Starbucks Corporation is an excellent case study of international companies that use transfer pricing to maximize profits. However, this accounting strategy has been met with much criticism with claims of not meeting its obligations in paying its taxes. The company was able to achieve a zero tax rate in the UK through payment of royalties to its subsidiary company located in Holland.
Through the transfer pricing strategy, the company was able to shift its profits overseas to maximize its profits. Google Inc. has also been accused of using transfer pricing as a means of shifting most of its revenues from Europe to its offshore subsidiary located in Bermuda. Its goal has been to avoid paying high taxes on the revenue it obtains. For instance, in 2013, the company only paid a sixth of one percent of the tax on its European revenue (Meadows, 2014).
Industries
Banking Industry
Kugiel and Jakobsen (2009) assert that most major banks apply the Fund Transfer System in their accounting. FTP is a system that facilitates the decomposition of income in the form of interest, which constitutes a huge portion of the banks’ profits. This goal is achieved by putting an internal price on the bank’s deposits, which are deducted in the form of a cost from the loans the banks provide to customers.
Moreover, the costs of bank loans can be calculated using the learning curve formula that takes into consideration the cost of sourcing the funds and the time is taken to process the loans. This plan increases the profitability of the bank. In addition, FTP facilitates the banks to calculate their income from loan interests. This process is applied to each branch, customer, and business line. By measuring profits at different levels, the bank can compare its internal operations about evaluation, effectiveness, and appraisal.
Oil and Gas Industries
According to McLean (2013), multinational petroleum firms set transfer prices that illustrate slight differences from their arms’ length prices. Ceterus Paribus, companies that produce crude oil in jurisdictions with corporate tax rates that exceed rates in the US use the transfer pricing strategy to reduce their tax obligations such as reporting their transfer prices to a bare minimum. The scope for these multinational petroleum corporations in using transfer prices as a means of reducing their tax obligations is founded on tax constraints in their host countries and/or the ability illustrated by the tax bodies in enforcing duty regulations.
In comparison with other industries, the oil and gas industry involves a greater amount of risk (McLean, 2013). For instance, larger investment capital is required in starting an oil company compared to other industries. Thus, mitigating the risk involved is a major concern of the oil companies. One of the advantages of using transfer pricing by multinational oil companies is that the entities involved in the transactions can share the cost of arrangements such as economies of scale, comprehension, proficiency, and the risk involved. Hence, by so doing, they reduce their risk, maximize their performance, and ultimately increase their profit margins (McLean, 2013).
Pharmaceutical Industry
The prospects of a multinational pharmaceutical company may rise and fall over a single drug (Armitage, 2015). Due to such pitfalls, multinational pharmaceutical companies dedicate a large number of financial and human resources such as researchers, executives, and marketers to the success of the next innovation. A common transaction in the pharmaceutical industry includes involving the Research and Development division. This unit is responsible for possession of data and patent, the expertise of the brand, marketing of the drug, and sale of a drug in a particular geographical location. In meeting its core obligations, the Research and Development division spends a lot of money on drug development and design before market approval.
Such costs involve huge risks, for instance, product failure that may affect the division’s profitability. One way of mitigating such risks is by applying the learning curve to estimate the capitalized expenditure where profits are split depending on costs incurred by the division. These costs are then adjusted for risk, money value, geographical scope, and time (Armitage, 2015). What results do companies expect after adopting transfer pricing? The succeeding section answers this question.
Results Achieved From Transfer Pricing
Profits
According to Shunko et al. (2014), a firm’s divisions can negotiate the transfer prices to be used in transactions or the central management of the firm can set prices after the transaction. The transfer prices that have been arrived at through negotiations have been shown to increase the gross profits of the firm from a transaction (Shunko et al., 2014).
On the other hand, administrative transfer prices are featured by the minimization of taxes, minority shared profit and compensation. In this scenario, the central management is fully in charge of controlling the transfer price after the transaction. Hence, it would be instinctive that profits from the divisions are not optimal before the transaction is carried out. Moreover, the learning curve should also be incorporated into the transfer-pricing model to motivate positive results by reducing costs and maximizing profits (Shunko et al., 2014).
Decision-making
International transfer pricing complicates decision-making regarding prices (Galusizka, 2007). A complex and highly debated issue relates to an interdivisional but cross-border transaction where activities are carried out under different jurisdictions. The different jurisdictions have the possibility of having large significant effects on the pricing. These differences pose a challenge when determining the transfer prices to use for the different transactions. However, to reduce such complications, organizations can apply the learning curve to estimate costs such as labor expenses, thus allowing them to make appropriate decisions regarding their transfer pricing strategies. Nonetheless, the price chosen will depend on the available options for the seller or buyer (Galusizka, 2007).
Performance Evaluation
As Usmen (2012) asserts, transfer pricing may assist first-line managers in the evaluation of the performance of profit centers. The assessment becomes easier since the top management can assess the individual performance of each center independently regarding the overall contribution of the profit centers to the corporate total profit. Transfer pricing intends to encourage managers, especially the middle administrators in charge of the profit centers, to act independently for the benefit of their centers. Moreover, the autonomy of the profit centers provides independence that enables the profit centers to integrate the learning curve into their management accounting such as cost estimates and reductions to improve the performance of their divisions.
Conclusion
Transfer pricing is an accounting strategy applied by firms as a strategy to reduce their taxation cost while increasing their profits. Multinational companies achieve various results after using the learning curve and transfer pricing as part of their accounting strategy. For instance, negotiated transfer prices determined through a learning curve would result in an increase in gross profit in the selling entity while an administrative transfer pricing set by the central organization, but fails to incorporate the learning curve, will have the opposite effect, including bad decisions. In terms of decision-making, transfer prices complicate the process, particularly where two divisions across borders under different jurisdictions are involved in transactions.
However, such complications can be mitigated by applying the learning curve to aid in making cost-based decisions such as labor costs. Transfer pricing encourages the respective divisional managers to excel in the performance of the respective divisions. However, among the three components, transfer-pricing best features profit maximization as the main outcome.
Reference List
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