All businesses exceeding an annual turnover of SAR 6 million are required to prepare and maintain a master transaction file as well as a local file. The CbC report submitted by MNEs is to include detailed information regarding aggregate company revenue, income tax paid, stated capital, accumulated earning, profit before tax, loss before tax, income tax accrued and the number of employees. The new bylaws can be ambiguous and complex for businesses, given various compliance requirements.
The transfer pricing policy for these organizations follows from the structure and systems. Internal transfers are mandated for both buying and selling units and the transfer price is full cost. Unlike in competitive organizations where the transfer price is a market price that determines whether sourcing will be internal or external, the transfer price in cooperative organizations is determined after the decision to source inside has already been made. The mandating of transfers is a direct consequence of the vertical integration strategy whereby the large capital investments involved make any other approach impractical.
Cooperative organizations measure performance of the total product flow across units, not of units as stand-alone profit centers. The purpose of transfer prices is to accumulate total costs as if the end products were manufactured completely within a single business unit. Actual full costs are calculated by dividing all fixed and variable expenses for a period into the number of units produced.
Because product costing involves valuing inventory, allocating joint product costs, and costing by-products, none of which is a precise science, costs are defined and calculated through management judgment and consensus. The major difficulty with actual full cost transfers is that the price of the intermediate good fluctuates. If either internal or external demand falls and the volume of the selling unit decreases, the transfer price to internal buyers increases.
Also, buying units do not know the price until the period is finished and the selling unit can calculate the actual costs.
A multi-billion-dollar chemical company with a sophisticated management control system used actual full-cost transfer prices. Actual full cost is not the chosen method of only the unsophisticated. In this company, buying divisions were told which plant to purchase from. Top management made these complex sourcing decisions to minimize transportation costs and to balance plant loadings for greatest manufacturing efficiency. Because product costs varied according to the producing plant, some managers were unhappy with this approach. Overall, however, managers showed little desire to change to standard-cost or market-based transfer prices.
We still pay them to run the business. Subjective judgment played a large role in evaluating a business unit manager. Company performance, business unit performance, and especially personal performance determined bonuses. If a company uses standard full-cost transfers, it can substantially reduce the variation in price the buying unit receives.
It also makes it possible to more clearly separate the profit-center external sales and cost-center internal transfer roles of the selling unit.
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Although nothing can eliminate it, standard full-cost transfers reduce the effect interdependence has on performance measures. Given the assumptions about volume, raw materials, and other expenses, standard costs are the expected unit costs of producing a product for some period. Standard costs are usually based on what it would cost to produce the good if the plant were running at nearly full capacity. A good standard-cost system attempts to identify the changes in volume or raw material costs that make the actual costs either higher or lower than the standard cost.
A standard-cost system can also isolate the effects the buying unit has on the selling unit, such as when the former buys less than anticipated. Determining whether variances are the responsibility of the buying or the selling unit is not easy. When selling unit managers have to interrupt long production runs for special orders, they may complain that the buying units are responsible for the resulting inefficiencies.
Buying divisions may argue that because cost decreases such as those for raw materials or utilities are not due to the purchasing acumen of the selling unit but to changes in market prices, the positive variances should be credited to the buying unit. The integrity of the standard-cost system depends on how the system is designed and operated.
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At issue is whether managers believe that the standard costs are what the costs really would be for an efficiently run operation. Buying unit managers have to believe that selling unit managers are doing their best to forecast raw material costs accurately. A common complaint is that these estimates are purposefully conservative so that the selling unit can show positive variances.
No ultimate accounting method can solve the problems inherent in standard full-cost transfers. These problems must be managed through processes that recognize the limitations of quantitative measures of performance. A chemical company in my study illustrates how a standard full-cost transfer pricing policy can be effective even when it does not include take-or-pay provisions.
In the mids, as part of a reorganization to a matrix structure, a task force recommended a market-based system to allocate variances. But in order to do this, I need to see all of the variances in one place, not scattered across 50 to 60 downstream products. Twenty years after the implementation of standard-cost transfer prices the sentiment is pretty much the same. It shows on one accounting document the relative contributions to profits of the individual products. Managers are evaluated on the basis of their contribution to the company in ways other than the profitability of their business units.
The company is located in a small town; nearly all of its managers are chemists and chemical engineers who were recruited right out of college and promoted within the company. It is a largely subjective judgment and includes a poll of their colleagues. Its an inherent philosophical and intellectual thing. We react to overall optimization. Even when managers mostly agree about what fair standard costs and variance allocations are, the standard full-cost method still causes problems.
The selling unit does not receive a profit on internal transfers, resulting in lower profit margins and return on investment percentages. One solution to this and other problems is to use a cost-plus-investment method for establishing the transfer price while retaining mandated internal sourcing. Several chemical companies, an electronics company, and a heavy machinery company in my study used this approach at some point. This approach essentially splits up the selling unit into an investment center based on external sales only and a cost center for internal transfers, and makes the buying unit responsible for profits and ROI on all internal resources used to manufacture its products.
Cost plus investment plays a function in cooperative companies similar to the one that dual pricing plays in competitive organizations. In both cases the objective is to obtain some of the advantages of the other organizational type. Cost-plus-investment transfer pricing also has its problems, many of which are related to allocating costs and investments. As conditions change, allocations, which are inevitably somewhat arbitrary, may not fairly reflect the balance between internal and external sales.
One company took nearly three years to make a cost-plus-investment approach work, and even then some key managers remained vehemently opposed to it. Companies that are collaborative emphasize both the interdependence of vertical integration and the independent contributions of the business units as diversified businesses. They combine characteristics of both competitive and cooperative organizations. As individual profit centers, the units compete; but as a result of high interdependence, they must cooperate. The inherent tension in this situation makes it possible for companies to obtain the benefits of the cooperative and competitive types but also makes them vulnerable to their problems.
For collaborative organizations, the transfer pricing problem is most complex. It is not clear on the MAP where an organization passes from competitive to collaborative or from cooperative to collaborative. As an organization moves toward the collaborative area—either through changes in transfer pricing policies or through increased strategic emphasis on interdependence through vertical integration or on independence through diversification—the transfer pricing problem becomes more difficult to manage.
As this occurs, management processes become increasingly important in designing the transfer pricing policy. In collaborative organizations the interplay of top-down and bottom-up planning approaches establishes strategy. As the balance between the objectives of the units working together and their individual objectives changes with conditions, the corporate strategy shifts.
Collaborative organizations are usually organized as matrix structures or as multidivisional structures that are substantially interdependent. Business units might share such resources as corporate manufacturing or sales units.
The structures of collaborative organizations are more complicated and messier than the clean multidivisional form of the competitive organization or the clean functional form of the cooperative organization. Supporting the diversification dimension of strategy are the results-oriented systems of the competitive type for top management control, while the hierarchical structure of the cooperative organization gives top management control in support of the interdependent vertical integration dimension of strategy.
Because of the tension between structure and systems in collaborative organizations, the primary mechanism of control is through management processes. This is a higher order form of control than in either of the other types. Top management must constantly guard against an excessive use of the functional structure or of the business unit systems; either can lead to the deterioration of the dimension of strategy associated with the other control mechanism.
The management processes shaping corporate-business unit relationships are iterative in nature. They combine both the bottom-up processes of the competitive type and the top-down processes of the cooperative type. Similarly, the processes shaping inter-business-unit relationships are those of mixed-mode bargaining. These processes combine distributive bargaining of the competitive type with integrative bargaining of the cooperative type. Iterative and mixed-mode bargaining processes are complex and require that the managers involved have sophisticated conflict resolution skills.
They also increase stress, which, if excessive, can hurt performance. Iterative processes make possible shifts of influence and control between levels and units as circumstances dictate. Mixed-mode bargaining processes between business units are a consequence of their simultaneously competitive and cooperative relationships. Due to the emphasis on systems for measuring quantitative results, business units have an incentive to win at the expense of others.
Structural interdependence, however, acts as an incentive for each business unit to be concerned with the performance of the other as it affects total corporate results. The dual focus that exists in measuring, evaluating, and rewarding performance reflects the mixed-mode bargaining. On the one hand, collaborative organizations use largely quantitative, objective criteria to assess individual business unit performance and to reward this performance. Executives take great efforts to establish objectives that contain measures of profitability and return on investment and to compare performance along these dimensions with similar external competitors.
On the other hand, given the very real dangers of managers attempting to improve unit performance at the expense of total corporate performance and the difficulty of finding comparable outside competitors, management tempers the quantitative approach with internal criteria such as cost-efficiency, total product performance, and other, more subjective, assessments. Bonuses for managers and capital budgets for units take into account both independent and interdependent contributions in a necessarily difficult-to-define combination of cooperative and competitive criteria.
The sense of fairness in collaborative organizations is based on a rational trust the unit managers have in top management.
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The rational component signifies the impartial spectator standards of fairness appropriate for competitive organizations. The trust component signifies the shared-fate standards of fairness appropriate for cooperative organizations. In collaborative organizations the required internal sourcing part of the transfer pricing policy of cooperative organizations is combined with the market-based transfer prices including cost-plus-profit-markup part of the transfer pricing policy of competitive organizations. Some companies move from the cooperative to the collaborative area because of increased diversification and a desire to put greater emphasis on individual unit performance.
Others want to increase entrepreneurial spirit to prepare for and facilitate increased diversification.
In companies that place a large emphasis on decentralized profit responsibility, selling unit managers are not likely to accept the argument that because cost transfers are built into the budget and objectives, they do not distort performance measures. When companies move from the competitive to the collaborative area it may be because they want to increase vertical integration and emphasize internal cooperation and the total product flow.
In collaborative organizations, market-based transfer prices play a different role than do prices in external markets and competitive organizations. In economic theory, price is a single-number transmitter of a great deal of information.
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Companies allocate resources and make decisions on trading relationships according to this number. Market-based transfer prices play a similar role in competitive organizations. Although they have less impact on capital allocation decisions, they do determine whether a buying unit sources internally or externally. When top management requires internal sourcing, market-based transfer prices become a source of conflict through which management can gather information and obtain control.
The conflict occurs because there is no completely satisfactory way to determine a fair market price.
Attack on the Issue…
Very large volumes of internal transactions do not have external counterparts, and the specifications of the product sold internally may vary from those of the product sold externally. Both units can argue that the transfer price is not a true market price because changes in transfer prices can significantly affect the performance measures of business units as profit centers and thus perceptions of their relative contributions to company profits. This information gives top management the control it needs to manage the business from a total product flow perspective. It is the kind of information that top managements in cooperative organizations have ready access to because their direct involvement is more accepted.
When internal sourcing is required, both units actively seek the involvement of top management to solve the transfer price conflict. Conflict is an inevitable element in the iterative and mixed-mode bargaining processes top management uses to exercise control in collaborative organizations. International transfer pricing issues are complex in nature, not only because they can involve large amounts of taxes, but also because their resolution depends on a clear understanding of the facts and context of each individual case and the jurisdictions involved.
This level of sophistication has made transfer pricing one of the most relevant tax issues that multinational enterprises and tax administrations have to take care of. Your request was sent successfully. We will contact you as soon as possible.