Transfer Pricing and Control Systems

In Chapter 12 we reviewed the various strategies that international businesses pursue. Two of these strategies, the global strategy and the transnational strategy, give rise to a globally dispersed web of productive activities. Firms pursuing these strategies disperse each value creation activity to its optimal location in the world. Thus, a product might be designed in one country, some of its components manufactured in a second country, other components manufactured in a third country, all assembled in a fourth country, and then sold worldwide.

The volume of intrafirm transactions in such firms is very high. The firms are continually shipping component parts and finished goods between subsidiaries in different countries. This poses a very important question: How should goods and services transferred between subsidiary companies in a multinational firm be priced? The price at which such goods and services are transferred is referred to as the transfer price.

The choice of transfer price can critically affect the performance of two subsidiaries that exchange goods or services. Consider this example: A French manufacturing subsidiary of a US multinational imports a major component from Brazil. It incorporates this part into a product that it sells in France for the equivalent of $230 per unit. The product costs $200 to manufacture, of which $100 goes to the Brazilian subsidiary to pay for the component part. The remaining $100 covers costs incurred in France. Thus, the French subsidiary earns $30 profit per unit.

	Before Change	After 20 Percent
	in Transfer	Increase in
	Price	Transfer Price
Revenues per unit	$230	$230
Cost of component per unit	100	120
Other costs per unit	100	100
Profit per unit	$30	$10

Look at what happens if corporate headquarters decides to increase transfer prices by 20 percent ($20 per unit). The French subsidiary's profits will fall by two-thirds from $30 per unit to $10 per unit. Thus, the performance of the French subsidiary depends on the transfer price for the component part imported from Brazil, and the transfer price is controlled by corporate headquarters. When setting budgets and reviewing a subsidiary's performance, corporate headquarters must keep in mind the distorting effect of transfer prices.

How should transfer prices be determined? We discuss this issue in detail in the next chapter. International businesses often manipulate transfer prices to minimize their worldwide tax liability, minimize import duties, and avoid government restrictions on capital flows. For now, however, it is enough to note that the transfer price must be considered when setting budgets and evaluating a subsidiary's performance.