Transfer Pricing

What is Transfer Pricing?

One of the concepts I teach as part of my Business Strategy course is Transfer Pricing. I define Transfer Pricing as a "management tool" for governing (some people might say "manipulating") transactions among related parties. Thereby, the transfer price is an artificially set price for a good or service that one party has to pay to another related party. If the transfer price varies from the market price, this pricing mechanism will make one party better off, at the expense of the other party.

 

How does Transfer Pricing work?

Let me give you the following example. Assume a company has two subsidiaries: 

Business Unit A is a manufacturing business unit located in Thailand which produces products to sell to internal and external business customers (not to consumers).

Business Unit B is our company's retail / distribution arm for the European Market. It gets its products from Business Unit A and sells it to end-consumers across Europe.

 

Scenario 1: Transaction at Market Prices

Let's assume the production cost for BU A is $50.- and it could sell its product to external businesses at a B2B market price of $100.-. The resulting profit per unit before tax would be $100 - $50 = $50. At 20% corporate tax rate in Thailand, the Net Profit After Tax (NPAT) of BU A is $50 - $10 = $40 per unit.

Assuming BU B buys the product from BU A at the B2B market price of $100 and can sell its products to European consumers at $200, BU B's profit before tax would be $200 - $100 = $100. At 30% corporate tax rate in Europe, BU B's NPAT is $100 - $30 = $70 per unit.

With this, our total consolidated company profit would be $40 + $70 = $110 per unit.

Exhibit 1 shows the details of this internal transaction at market prices.

Scenario 2: Transaction at Transfer Pricing (with factor 1.5)

Now, let's assume our company decides to implement a new transfer pricing policy that would allow BU A to charge to BU B at 1.5x market price. The production cost of $50.- remain unchanged. 

Under this new scheme, BU A can now sell its product to BU B at a transfer price of $100.- x 1.5 = $150. As a result, profit per unit before tax increases from $50 previously to now $150 - $50 = $100. With 20% corporate tax rate in Thailand, the Net Profit After Tax (NPAT) of BU A increases to $100 - $20 = $80 per unit. Therefore, BU A doubles its NPAT from $40 to $80.

BU B, on the other side, now has to pay significantly more for its products. It buys from BU A at the transfer price of $150, and with consumer market price unchanged at $200, BU B's profit before tax reduces to $200 - $150 = $50. At 30% corporate tax rate in Europe, BU B's NPAT is now $50 - $15 = $35 per unit. Therefore, BU B is significantly worse off compared to before.

However, our total consolidated company profit improves from $110 per unit to $80 + $35 = $115 per unit. 

Exhibit 2 shows the details of the transaction with transfer pricing.

 

It is worth to note that our consolidated profit before tax has remained unchanged: At market prices, it was $50 + $100 = $150; at transfer prices it is now $100 + $50 = $150. All transfer pricing has done is to make one BU look better on paper, while the other BU looks worse. Operationally, nothing has changed, so the change in financial performance literally just happened on paper.

After tax, however, with the help of transfer pricing, we have managed to increase our total after-tax profit. The improvement comes from tax savings: Previously, we paid a total of ($10) + ($30) = ($40) in taxes. With transfer pricing, our taxes decrease to ($20) + ($15) = ($35).

Pros and Cons of Transfer Pricing

The benefit of transfer pricing is obvious from the example above: With tax rates varying among between countries, multinational companies can benefit from tax arbitrage by shifting profits to geographies with lower tax rates. 

Other reasons for transfer pricing could be that management tries to "push" BUs to improve their performance by "storing" profits at a particular BU, forcing the other BUs to lower their cost, increase their prices, etc. in order to manage their performance.

The challenge with transfer pricing is that it artificially increases / decreases the performance of BUs without underlying operational rationale. With this, there is a risk that investment decisions are made in favor of a BU that benefits from transfer pricing, while another BU might be disadvantaged as its result look unfavorable, while its actual operating performance is stronger than Accounting numbers might suggest.

Similarly, managers and staff working in the "disadvantaged" BU might be wrongly considered as under-performers, while one of the key contributors to the financial performance of their BU might in fact the transfer pricing mechanism.

This requires close monitoring from management in order to avoid driving wrong investment and performance management decisions.

---------------------------------------

Sources:

https://www.cesim.com/

https://www.investopedia.com/terms/t/transferprice.asp

What is Strategy ?

Starting from the origins

When talking about a new topic or subject, it makes sense to start off with a clear definition of what we it actually is we are talking about. For the subject of "Strategy", one good starting point is the root of the word itself (also because it gives me the rare chance to show-off my classical education in Ancient Greek and Latin...). 

Looking at the etymology of the word "strategy", it actually originates from two Ancient Greek words: "ho stratos" (the army) and "agein" (to lead). So, the word "strategy" is actually war terminology: It literally refers to the art of leading an army in a war or a battle - to victory, of course! Please note that embedded in the word "strategy" is not only the plan on how to win the war, but also the aspect of "leadership" - a concept we will get back to repeatedly when discussing the subject of strategy.

Taking this concept to the business world, strategy means having a plan on how we as leaders can steer our business to beat the competition and get ahead of the market, and then act on the plan by implementing these strategies and lead our business to outperform our competitors.

 

A formal definition of "Strategy"

Any academic discussion of a subject needs to kick off with a proper formal definition of the subject. If you look through literature, you will find a myriad of definitions, all with slight variations. Here a few:

• Alfred D. Chandler (1963):
  

  "(...) the determination of the long-run goals and objectives of an enterprise and the adoption of courses of action and the allocation of resource necessary for carrying out these goals"

• Michael E. Porter (1996):
  

  "Competitive strategy is about being different. It means deliberately choosing a different set of activities to delivery a unique mix of value"

• Henry Mintzberg (2007):
  

  "(...) a pattern in a stream of decisions"

• Gerry Johnson et al. (2015):
  

  "strategy is the long-term direction of an organization"  

Personally, the one I like best and the one I refer to in my lectures is from Hitt, Ireland, Hoskisson (2019):

"An integrated and coordinated set of commitments and actions, designed to exploit core competencies, with the aim to gain a competitive advantage".

 In a nutshell: Strategy is a well crafted plan that lays out how to win against competition. 

Strategy vs. Tactics

Finally, one important distinction we need to make is the difference of Strategy as opposed to Tactics. Many times I have heard people say: "My strategy for next week's promotion is...". The way I like to look at it, strategy is something for the longer-term: a plan that covers at least the next full year period, but many companies looking at 3-5 year horizons. This longer-term strategic plan should be closely aligned with the even longer-term vision and mission of the company (more about this in a separate post).

Supporting the longer-term strategic plan are a number of smaller tactical initiatives (like next week's promotion campaign, for example), which become the "operationalization" of our strategy. 

The key challenge for business leaders is to ensure that all these small tactical initiatives indeed are fully aligned with the long-term strategic plan. In my 15+ years experience working in various strategic functions (as a consultant as well as in corporate strategy functions across several businesses), whenever I have seen strategies fail, it was due to management taking too many short-term tactical actions that were not aligned with overall strategy, and that distracted the organization from its original direction. 

If you take the analogy: If your long-term goal is to lose weight, it doesn't help if you eat too many sweets, chips and drink too many sugary drinks... :)

 

 ---------------------------------------

Sources:

Chandler, A.D. (1963): "Strategy and Structure: Chapters in the History of American Enterprise"; MIT Press, 1963, p. 13.

Hitt, M.; Ireland, R.D.; Hoskisson, R. (2019): "Strategic Management: Concepts and Cases: Competitiveness and Globalization"; 13th edition, CENGAGE Learning Custom Publishing, 2019.

Johnson, G; Whittington, R.; Scholes, K.; Angwin, D.; Regner, P. (2015): "Fundamentals of Strategy"; 3rd edition, Pearson, 2015.

Mintzbert, H. (2007): "Tracking Strategies: Towards a General Theory"; Oxford University Press, 2007, p. 3.

Porter, M.E. (1996): "What is Strategy?"; Harvard Business Review, Nov-Dec 1996, p. 60.