Allocated Costs and Transfer Pricing, page 1 of 4

ALLOCATED COSTS AND TRANFER PRICING

L. Schall

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, both of which we discuss below. Allocated costs and transfer pricing as they relate to performance evaluation are not covered here. ALLOCATED COSTS DEFINITION OF ALLOCATED COST: An allocated cost is a book-keeping charge imposed on a unit (a product, project, profit center, division, subsidiary, etc.) in order to reflect that units share of a cost that has not already been assigned to the unit (the unassigned cost). For example, suppose that Star Corporation has two divisions, Alfa and Bayduh, and assume that Stars assignment of home office operational costs (management, legal department, accounting, etc.) to a subsidiary are based on the subsidiarys direct-labor hours incurred. Star has $30 million of home office annual costs that it wants to allocate Alfa and Bayduh. Alfa and Bayduh annually incur, respectively, 100 million hours and 200 million hours of direct labor costs. In this case, Star would allocate the $30 million of home expense as follows: $10 million to Alfa and $20 million to Bayduh (10 cents per direct labor hour). If Alfa were to propose a new investment requiring 300,000 labor hours annually, it would be required to include $30,000 per year (300,000 10 cents) as an expense in the investment proposal. PROPER TREATMENT OF ALLOCATED COSTS IN INVESTMENT ANALYSIS: The relevant overhead cost to be assigned to an investment is the estimated incremental cash flow impact of the investment on the expenses of parent. For example, suppose that a subsidiarys 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 hours 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 annual cost is $2 million, not $1.7 million.

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TRANSFER PRICING DEFINITION OF TRANSFER PRICING: When an item (a good or service) is transferred from one business unit of a firm to another business unit of the same firm (e.g., one division to another), the transfer is recorded as a sale by the supplying entity and as a purchase by the acquiring entity. The per unit price charged for the transferred item is called the transfer price. To illustrate, suppose that Star Corporations Alpha Division considering Project Blue, which will require 2,000 units of an input manufactured by Stars Bayduh Division. Bayduh will charge Alfa a transfer price of say, $100 per unit, or $200,000, for the transferred goods. The $200,000 charge may be a bookkeeping entry or an actual transfer of cash, depending on circumstances. The $200,000 is recorded as a cost in the Project Blue proposal. So, this transfer price will affect the computed NPV of the project, and perhaps determine whether Project Blue is adopted. The $200,000 is generally computed on a precorporate tax basis. 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; otherwise, tax differences will have to be considered. TRANSFER PRICING AND INVESTMENT ANALYSIS: The optimal transfer price is the one that induces firm value maximizing investment behavior. This price is the amount necessary to exactly compensate the provider of the good or service (e.g., in the above illustration, to compensate Bayduh Division for the transfer of goods to Alfa Division). Transfer prices can influence: (a) whether an item will be acquired internally (i.e., from another segment or division of the same company) or from another firm; and (b) the quantity and quality of the item acquired. Example 1: Division X will provide 500 hours of consulting services to Division Y. Because of an inability to hire additional competent staff, Division X will use existing productive staff to provide the 500 hours of consulting services to Division Y. As a result, Division X will reduce its sale of services to other (nonBigCorp) companies; the fees for the 500 hours would be $100,000. The appropriate pretax transfer price (pre-tax cost) for Division Ys investment analysis is $100,000. This is because a $100,000 benefit was given up by X in providing the services to Y.

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Example 2: Division X will use existing idle staff to provide the 500 hours of consulting services to Division Y. If the services are not provided to Division Y, the idle Division X staff will produce nothing. The appropriate transfer price (cost) for Division Ys investment analysis is $0. On the other hand, suppose that, if the services are not provided to Division Y, the idle Division X staff will reduce the productivity of other Division X workers by $6,000 per month (by engaging them in non-business conversation). The appropriate transfer price (cost) for Division Ys investment analysis is $6,000 per month (Division X should pay Division Y $6,000 to temporarily absorb the idle Division X employees). Example 3: Division X will hire additional temporary staff to provide 500 hours of consulting services to Division Y. In addition to wages paid to the temporary staff, Division X will train the temporary staff so that the staff will be prepared to work on the Division Y project. The total incremental cost to Division X will be the wages to the temporary staff, training costs, incremental costs of arranging the temporary employment and allocation to Division Y, etc.; suppose that these costs total $67,000. The appropriate transfer price (cost) for Division Ys investment analysis is $67,000. Example 4: Suppose that Division X produces product M. BigCorp Division Y needs units of M as an input of production and can purchase M from Division X. Because of lower billing and shipping costs in providing M to Division Y relative to an outside customer, the cost of providing M to Division Y is $40, whereas the cost of providing M to outside customers is $45. Division X sells M in the market for $70 per unit, producing a per unit pretax net return of $25 per unit ($25 = $70 $45). Thus, Division X sacrifices $25 of net return for each unit of M provided to Division Y. Since the cost of providing a unit of M to Division Y is only $40 rather than $45 (the cost if M is sold to outside customers), the transfer price for product M supplied by Division X to Division Y should be $65, which results in the same $25 net return earned on a sale to outside buyers. 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. These tax effects depend on U.S. tax law and on the treaties with the foreign countries. The after-tax cost of producing and selling a product will depend on where the
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product is produced, where the inputs of production come from, and on where the product is sold. 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. Major accounting firms have specialists who do nothing but transfer pricing. This is an enormously complex problem. The objective is the highest after-tax cash flow for the parent and its subsidiaries. Achieving this goal in part depends on transfer prices that induce the optimal investment incentives in light of tax effects.