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Strategy tools: Effective transfer pricing

Marc Wilson

6 Jan 2021

Photo by JOHN TOWNER on Unsplash

By Marc Wilson

Marc is a partner at Global Advisors and is based in Johannesburg, South Africa.

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So much has been written about transfer pricing. Yet it remains a bone of contention in almost every organisation. Transfer pricing is not merely a rational challenge – it often raises the emotions of internal service users and providers who argue regarding scope, quality, price and value.

We have found that effective transfer pricing relies on some fairly simple best practices and critical success factors.

Many organisations recover costs as a regular 'below-the-line' deduction from operating division income statements. In our experience, charge out is almost always preferable. This results in internal value judgements and negotiation regarding delivery happening closer to time of use.

Internal prices / cost recovery plays a crucial role within an organisation: it 'price signals' to the buyer and the supplier of the service. Buyers make economic use decisions and suppliers make resource and capacity decisions. This fundamental function and consequence governs the optimal implementation of internal pricing / cost recovery.

We have typically seen that the realisation that internal pricing plays this role and the consequences of poor implementation are not well understood.

Results

Results of poor transfer pricing implementation

Sub-optimal economic use decisions

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Sub-optimal investment and resourcing decisions

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Political and emotional argument

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Poor product / service quality

Sub-optimal economic use decisions

Where costs / prices are higher than they should be, buyers pass this on as an inflated cost to their customers, experience margin squeeze, or utilise less of the service than they might have.
Strategically this can lead to incorrect decisions regarding the provision of services to the market and loss of market share.
Where costs / prices are lower than they should be, this can lead to overuse of a product or service and poor cost recovery from external customers.
Strategically this can result in the over promotion and sales of products and services that are achieving lower margins than thought, or that might even be making losses.

Sub-optimal investment and resourcing decisions

Incorrect pricing can lead to over- or under-investment in capacity and product or service quality. Further, the resourcing decisions will be incorrect should the price signal to the supplier be incorrect.

Political and emotional argument

Where buyers are unable to obtain assurance that an internal price is correct, there is typically resentment regarding the cost of the internal product and service and the sheltered position employees of the internal service provider occupy – in the buyer's eyes free from commercial pressures.
Buyers and suppliers typically also argue regarding the quality of the service or product relative to the price paid.
Suppliers may react to criticism claiming their product or service is strategic in nature and refute its availability in the external markets.

Poor product / service quality

Poor price signals will result in lack of comparable product and service quality benchmarks. This can result in 'gold-plating' or poor-quality product and service provision.

Difficulties are usually experienced when shared resources within the firm are not split equitably amongst divisions. The Harvard Business Review relates that Telcordia (previously part of AT&T) was experiencing inappropriate transfer pricing due to labour intensive units receiving disproportionately more costs from IT services because of their headcount. The consequence was inappropriately high pricing for basic services (secretarial etc.) to other departments with higher paid staff. The higher paid staff began to spend more time on non-core activities, which not only impacted their profitability but also rendered the labour-intensive units unused. By properly allocating costs, transfer prices were eventually set equitably and all business units were able to run far more effectively as profit centres.

We have conclusively found market-based pricing to be preferable over cost recovery in almost all instances.

There is often resistance to the idea of running an internal service as a profit centre (the price equals a market price or cost plus a mark-up) due to the perception that the internal service provider will be incentivised to earn as much as possible from a captive client. In the case where an internal service provider merely marks up a cost, this criticism is entirely correct. Best practice demonstrates that profit centre prices must almost always be equivalent to market prices where similar products and services can be found in the market. This ensures optimum price signalling and ensures that internal buyers are satisfied that commercial-like behaviour is incentivised. In order to follow this approach, buyers must be allowed a choice of purchasing products and services from the market to ensure internal and external quality and efficiencies are matched and suppliers should be allowed to price and service quality match to avoid internal stranded costs. Where an organisation implements this approach, we typically recommend a sunset period on previously captive market agreements during which the internal service provider can optimise to meet market conditions and adopt commercial-like behaviour.

Where internal products are not available externally or external products and services are not equivalent to those available internally, internal service providers must mark-up a benchmarked / jointly-agreed efficient cost of provision. Mark-ups are typically benchmarked to similar industry players to arrive at a fair return. This is a difficult process and in such a case, organisations may default to more traditional cost-centre pricing.

Cost-recovery pricing seldom accounts for recovery of costs-of-capital.

Where organisations do adopt cost-centre pricing, it is our experience that they seldom account for costs-of-capital.

This results in poor price signalling, where value judgements are made based on understated costs. Further, an organisation's attempt to achieve an economic (or Economic Value Added) return will fall short if the internal service provider's capital is not taken into account in pricing of products and services provided to external customers.

The Chartered Institute of Management Accountants (CIMA) recommends that at the very least, where external markets for internal goods and services exist, these should be priced on an opportunity-cost basis – this incentivises profit maximisation for the enterprise as a whole . They further recommend adjustments for capacity utilisation. While this approach encourages organisational profit maximisation – and accounts for goods and services with an external market but not necessarily a competitor-set market price, we find that market-determined prices are preferable due to the aforementioned price signalling benefits and the practical constraints CIMA draws attention to.

We have found that agreement of a costing and recovery/charge-out approach requires addressing complex political and emotional issues. Stakeholders have a vested interest in agreeing an approach that minimises the cost to them. In order to agree an approach that inspires the right outcomes, it is essential that facts and costs are accurately understood in parallel to developing and agreeing governing principles upon which methodology and process can be agreed. Further, in order to ensure principles do in fact encompass best practice and the goals of the organisation, careful attention must be paid to the composition of the steering group. Our experience has proved the value of agreeing internal pricing principles at an organisation level with case-specific application. Perceived fairness is absolutely crucial.

A crucial ancillary process to internal pricing, is the agreement of service level agreements.

If costing has been correctly determined and pricing processes effectively implemented, we have found that a crucial ancillary process is the agreement of service level agreements.

This allows buyers and internal suppliers to agree the quality of service for the attached price, and in the case of utilising a market price, that the quality-of-service provision is the same as that provided in the marketplace.
It is critical that as organisations understand their costs and agree recovery mechanisms and service level agreements, that they implement processes, systems and structures to maintain these going forward. Achieving effective internal pricing is an ongoing journey.

Taxation and financial accounting requirements can introduce complexity into transfer pricing. It is critical to ensure the correct internal process is adopted to drive optimum behaviour. This might result in different treatment of transfer pricing for management and incentivisation purposes to that adopted for accounting treatment. On many occasions, fair pricing principles required by accounting and tax standards align with good pricing practice, but on occasion lack of optimisation can result in poor tax and accounting outcomes.

It is not sufficient to arrive at agreed internal services, fair prices and accurate costs. Ongoing work is required to maintain these and the good perception and buy-in to results.

While implementing the optimum costing and charge-out regime within a business is complex, CIMA finds that correct costing and charge out encourages business units to perform more efficiently and effectively.

Global Advisors have substantial experience in internal / transfer pricing and costing. We have worked to align internal pricing with overall strategic and business model goals and delivered hands-on implementation from individual prices and costing in ERP systems through to processes, reporting and incentivisation.

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References

Kovac, EJ; Troy, HP – 'Getting Transfer Prices Right: What Bellcore Did' – Harvard Business Review – September 1989 – http://hbr.org/1989/09/getting-transfer-prices-right-what-bellcore-did/ar/6

Scarlett, B – 'Opportunity knocks' – CIMA Insider – April 2004 – http://www.cimaglobal.com/Documents/ImportedDocuments/ci_april_04_p20_21.pdf

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