INTRAFIRM TRANSACTIONS: ALLOCATED COSTS AND TRANFER PRICING
Particularly in large companies, transfers of goods and services made between separate operating units are “priced” for the purpose of making investment and other resource allocation decisions. Two key ways in which this can affect investment analysis are through allocated costs and transfer pricing. Keep in mind that the issue addressed below is the use of allocated costs and transfer pricing for investment and asset allocation decisions within the company. Allocated costs and transfer pricing as they relate to performance evaluation are not addressed here.
ALLOCATED COSTS
Definition of Allocated Cost: A book-keeping charge imposed on a unit (a product, project, profit center, division, subsidiary, etc.) in order to reflect that unit’s share of a cost that has not already been assigned to the unit (the “unassigned cost”). Example: A parent’s assignment of the cost of the home office operations to the firm’s subsidiaries based on the subsidiaries’ direct labor expenses.
Treatment of Allocated Costs in Investment Analysis: The relevant cost (the relevant charge) to be assigned to a unit is the estimated incremental cash flow cost caused by the unit. If the allocated cost is significantly different from the estimated incremental cash flow cost, then ignore the allocated cost. Example: A subsidiary’s plant expansion is expected to increase the expenses (on a cash basis) of the home office by $2 million per year; whereas the allocated cost based on incremental direct labor to be incurred by the plant is $1.7 million per year. In analyzing the plant expansion (that is, in doing DCF analysis to determine whether or not to undertake the expansion), the relevant estimated future cost is $2 million, not $1.7 million.
Rationale: The objective is to maximize the value of the entire firm’s equity (equity in the parent and the subsidiaries combined). That value depends on the equity cash flow generated by the whole company. Therefore, forecasted actual cash expenses, not forecasted cost estimates based on allocation rules, should be used in the DCF analysis.
TRANSFER PRICING
Definition of Transfer Pricing: Transfer pricing is the assignment of a price to an item (an asset, good or service) that is being transferred (“sold”) by one business unit of a company to another business unit of the same company. The “entire company” refers to all units of the company combined. Example: BigCorp has multiple divisions. Division A provides 500 hours of consulting services to Division B and charges Division B $50,000 for those services (the charge may be a book-keeping entry or an actual transfer of cash, depending on circumstances). Note that the $50,000 transfer price is generally computed on a pre-corporate tax basis, that is, it is comparable from a tax perspective to a charge that an outside supplier would impose for goods or services provided to Division B. If all business units are subject to the same tax rate (e.g., if the company files a consolidated tax return), the analysis can be done on a pretax basis; if the units face different tax rates, the tax differences will have to be considered.
Treatment of Transfer Pricing in Investment Analysis: There are two issues. [a] The first is whether a good or service should be acquired internally from another organizational unit or purchased in the market. The optimal choice is the one that creates the best after-tax cash flow consequences for the entire company. [b] The second issue is how to determine the transfer price. The correct transfer price for investment decisions by the recipient of the transferred item is the sacrifice by the entire company in providing that item.
Rationale: As with the issue of allocated overhead, transfer pricing should serve the objective of maximizing the value of the entire company’s equity. Equity value depends on the equitycash flow generated by the whole company. Therefore, a company-wide perspective should be used in all decisions, including investment decisions. Consequently, the transfer price for item provided by unit A to unit B should be the sacrifice incurred by the entire company in providing that item to B.
INTRAUNIT TRANSFERS: Before we get transfer pricing for transfers between units, consider for a moment a transfer within a unit. Suppose that employee Carl Rokker works in the Marketing Department of Division Q. Rokker is currently paid $40 per hour but is expected over the next 3 months to generate only $10 per hour in benefits for the firm because of a slowdown in business. It has been decided that Rokker should not be terminated because he is very competent, and starting in several months he will generate returns for the company exceeding the $40 he is being paid. Furthermore, replacing someone with Rokker’s productivity in Marketing would cost $45 per hour. Assume that Rokker would have no cost-effective role in the company outside of Division Q’s Marketing and Purchasing Departments.
Management is considering the temporary assignment of Rokker to the Purchasing Department. In making this decision, the guiding principle is as follows: The transfer is justified only if it benefits the company as a whole. In Case I below, Division Q’s PurchasingDepartment wants to use Rokker for the next 45 days; it is expected that Rokker will generate $25 per hour in benefits in the Purchasing Department. You are the manager of Division Q. Would you transfer Rokker from Marketing to Purchasing for the next 45 days? The answer is Yes, because the sacrifice (to the firm as a whole) of doing so is the $10 per hour of productivity in Marketing whereas the benefit is the $25 productivity in Purchasing. The correct “transfer price” in this case is $10 per hour. The reason is that the company is sacrificing the $10 by removing Rokker from the Marketing Department.
Now see if you can solve Cases II, III and IV by applying the reasoning we just used for Case I.
Case I / Case II / Case III / Case IVRokker’s current salary per hour paid by Marketing / $40 / $40 / $40 / $40
Short-term value per hour of Rokker in Marketing / $10 / $10 / $10 / $10
Value per hour of Rokker in Purchasing / $25 / $25 / $8 / $18
Cost of new hire alternative to Rokker in Purchasing* / $20 / $28 / $20 / $7
Transfer price of Rokker / $10 / $10 / $10 / $10
Should Rokker temporarily go to Purchasing? / Yes / Yes / No / No
* The alternative to Rokker would have the same productivity in Marketing as would Rokker.
INTERUNIT TRANSFERS: Assume that Divisions A and Division B are divisions of multinational corporation BigCorp, Inc. BigCorp Division A provides services to other divisions within BigCorp and also sells its services to companies outside of BigCorp. BigCorp Division B is considering the construction of a new facility and will require the consulting services of Division A to accomplish this task. The cost of those services must be entered into B’s NPV analysis of the proposed new facility. Below are some alternative scenarios that might apply.
Example 1: Division A will provide 500 hours of consulting services to Division B. Because of an inability to hire additional competent staff, Division A will useexisting productive staff to provide the 500 hours of consulting services to Division B. As a result, Division A will reduce its sale of services to other (non-BigCorp) companies; the fees for the 500 hours would be $100,000. The appropriate pretax transfer price (pre-tax cost) for Division B’s investment analysis is $100,000. This is because a $100,000 benefit was given up by A in providing the services to B.
Example 2: Division A will use existing idle staff to provide the 500 hours of consulting services to Division B. If the services are not provided to Division B, the idle Division A staff will produce nothing. The appropriate transfer price (cost) for Division B’s investment analysis is $0. On the other had, suppose that, if the services are not provided to Division B, the idle Division A staff will reduce the productivity of other Division A workers by $6,000 (by engaging them in non-business conversation). The appropriate transfer price (cost) for Division B’s investment analysis is $6,000.
Example 3: Division A will hire additional temporary staff to provide 500 hours of consulting services to Division B. In addition to wages paid to the temporary staff, Division A will train the temporary staff so that the staff will be prepared to work on the Division B project. The total incremental cost to Division A will be the wages to the temporary staff, training costs, incremental costs of arranging the temporary employment and allocation to Division B, etc.; suppose that these costs total $67,000. The appropriate transfer price (cost) for Division B’s investment analysis is $67,000.
Example 4: Suppose that, due to limited plant and equipment, BigCorp Division A can produce no more than 2 million units of product M over the next 6 months. Demand for product M is sufficiently strong that the sale of 2 million units can be achieved. BigCorp Division B needs units of M as an input of production and can purchase M from Division A. Because of lower billing and shipping costs in providing M to Division B relative to outside customer, the cost of providing M to Division B is $40, whereas the cost of providing M to outside customers is $45. Division A sells M in the market for $70 per unit, producing a per unit pretax net return of $25 per unit ($25 = $70 $45). Therefore, Division A sacrifices $25 of return for each unit of M provided to Division B. The transfer price for product M supplied by Division A to Division B should therefore be $65 (rather than market price $70), since $65 is the gross price charged to Division B that produces the $25 net gain to Division A that would have been obtained by selling the units of M in the market. The $65 transfer price will motivate the optimal (firm value maximizing) resource allocation for the firm.
Example 5: A multinational firm that transfers goods and services among its subunits (divisions and subsidiaries) must take into account the resulting tax effects in the various countries in which the sub-units are located. The after-tax cost of producing a product will depend on where the product is produced and on the sources of the inputs of production. Part of the tax optimization process is to optimally establish, within the bounds allowed by the laws of the countries involved, the pricing and sources of goods and services exchanged by the sub-units. To illustrate, suppose that BigCorp Division X is located in Chile and BigCorp Division Y is located in the United States. U. S. Division Y imports an input, product Q, from Chilean Division X. The total tax effect (U.S. plus Chilean taxes) from this transaction will depend on the price that Division X charges Division Y for units of Q, on the tax laws in the U.S. and Chile, and on BigCorp’s particular tax situation in the two countries. These tax effects impact the transfer price that should be assigned to imported input Q used by Division Y for its operations. The optimal transfer price is unlikely to equal the U.S. or Chilean marketprice of Q. The reason is that the market price does not take into account the particular tax consequences for BigCorp of transferring Q from Division X to Division Y. In solving this type of problem, BigCorp would compare foreign and domestic sources of acquiring Q and then use the source that results in the greatest after-tax (domestic and foreign tax) returns to BigCorp. This analysis is likely to very complex.
4/29/2004
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