Happy Transfer Pricing

A newly appointed Managing Director of a Biotech Company, who believed in participative leadership, wanted to increase organizational efficiency of his organization and save costs. So, he invited all the departmental managers for generating ideas but the brain storming session turned into a heated debate and counter firing. Disappointed Managing Director was puzzled as to how all the negative interactions and other hidden ego issues between these managers should be solved or otherwise the work environment and the business will suffer hugely.

He shared his worries with his old friend who was a risk consultant and he immediately spotted the role of management accounting which plays a powerful role in encouraging or discouraging such interactions. The management accounting system recognizes the interactions of different responsibility centers through Transfer Pricing, a system of pricing product or services transferred within the same organization.

The Managing Director said that Transfer Pricing is not a big issue as he has appointed a renowned tax advisory firm. His friend told him that Transfer Prices are much more rooted than this and are prevalent in organization than most managers realize. Consider the charge which the advertisement department receives from maintenance department for janitorial services or a monthly charge for telephones, security services, data processing, or legal and personnel services. This cost distribution is internal Transfer Prices. There are three main reasons for Transfer Pricing within the firm. These are control purpose i.e. setting incentives and performance measures, decentralized planning decisions and international tax etc reasons. All these factors should be considered in setting Transfer Prices.

"What does that mean?" asked immediately the Managing Director as he had thought that Transfer Pricing issue was already taken care of in his organization. His friend then told him that Transfer Pricing is used for control and planning purposes in a decentralized organization. To determine performance of a manager and his profit and investment centre requires use of Transfer Pricing when goods or services are transferred within the organization.

Transfer Pricing should lead to performance measures that discriminate between good and bad managers. In other words, manager's responsibility centre should not be penalized by Transfer Prices that are affected by the performance of the manager of other responsibility centre. For e.g. manager of engineering department should not be able to charge the manager of production department for cost overrun due mistake the engineering department made.

Similarly, in case of planning decisions, the managers of a responsibility centre make certain input and output decisions. But many a times he is not allowed to go outside the organization for sourcing or selling. In such a situation manager can resort to such decisions or maintain same level of efficiency in absence of any competitive pressure which are not consistent with the entire organization's goal. Thus Transfer Price should be less subject to managerial discretion to encourage operational efficiency and organizational harmony.

He immediately asked his friend to look into the controls related to performance measures and existing transfer pricing practices within his organization.

Brand Shift

A blue chip Company into consumer goods having various brands found that as per recent market survey its products' brand expectations in the market were shifted unexpectedly during the last year. The Managing Director of the company called for an urgent meeting of its senior managers to seek an explanation but failed to find any major problems with the current management of the business which may have caused it.

The confused Managing Director approached a boutique business advisory firm for the solution. The boutique business advisory firm started with analysis of its business performance and the factors attributing. After few weeks of analysis, the initial hypothesis set by the advisors proved correct that one of its investment centers was not working on multiple performance measures causing the problem for the entire business.

An organization having multiple goals cannot motivate the manager to consider those goals with a single performance measurement. It was found out that the Company had entered into business of an ancillary product two years back, which was facing quality problems.

The managers of this business had been evaluated on basis of their profit and ROI targets and thus to reduce cost, the managers had reduced the quality of the product compared to the quality expectation of the customer. Over time, consumers came to learn of the lower-than-expected-quality of the ancillary product. The business managers of the ancillary product although had exceeded their short term target profits, but the market had lowered its expectation of quality for all the products of the Company.

To control any future problems, the senior managers were advised to continually monitor the quality of all the products including ancillary products to ensure that they meet the Company's quality standards. The investment centre managers should be constrained in terms of quality of products that they can sell and the market niches that they can enter. The reasons for these constraints prevent these managers from demeaning the firm's brand reputation.

It was further advised that the firm should disassociate itself from the disreputed ancillary brand to reduce the impact on its other major brands. It was an eye opener and The Managing Director had realized the strategic connection of business performance with the management accounting and importance of having multiple performance measurement. Eventually, the Company sold the business of the said ancillary product to some private investors.