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April 2, 2011

Transfer Pricing in Lean Accounting

Setting a transfer price is one of the most difficult operations that lean accounting faces because accountants sometimes assert that they need a standard cost for tax and customs purposes. In fact standard cost is no more acceptable than any other form of cost to the tax authorities, who are seeking proof that the transfer price is a reasonable “arm’s length” equivalent. I have experienced two clients recently working towards lean accounting who have tackled the issue of Transfer pricing in different ways.

 

Our first client, based in the UK, needed a Transfer Price to transfer products from manufacturing locations to sales units in different countries (both within the European Union and further afield). Tax optimisation for the group was the primary objective. The framework for tax law on transfer pricing and duty in most countries is derived from OECD guidelines. In broad terms the tax authorities were looking to evaluate three factors:

  • Where the risk in the transaction lies. The tax authorities will examine how the balance of risk lies between the parties. Which location bears the currency risk; the customer risk (the cost of returns, bad debts etc); or the product risk (liability) ?. If these risks are all borne by the manufacturing location, for example, then the sales location would be expected only to make a small profit margin;
  • That the costs “absorbed” in the transfer price are reasonable. The tax authorities require a clear auditable policy statement (method) that shows how the costs in the transfer price are built up, and that this method is fair and reasonable. General or corporate overheads not specifically related to the product being transferred may be rejected by the authorities.
  • Given the first two factors, that the profit margin in the transfer price is deemed “acceptable”. There is no definition of what this means, but there are large databases of the margins made by every company in every sector that move product across borders, as well as commercial profit margins. The margin made by the transferring partner should lie within this range. It is also worth noting that period payments between the parties (such as management fees, or profit sharing payments) will also be considered by the tax and duty authorities.

 

Our UK client took a radical approach deciding to transfer each product at direct material cost (moving average) only – with a single monthly “true up” of profit by an approved method. Thus, instead of having to calculate a fully absorbed transfer price for each product – which took the company at least three months each year – a single journal entry was required using the approved method of calculating an acceptable margin. This not only released months of time in the finance department, it also allowed operational and sales decisions to be made transparently on the basis of the real ability to fulfil an order (using contribution costing and the capacity of the Value Stream), as opposed to making sub-optimal decision on the basis of the transfer price (with orders being rejected because they didn’t make sufficient margin on the transfer price, when, in fact, the company had plenty of spare capacity and the order would have made a positive contribution).

 

The only complication in this simple scheme is the need to gain the approval of the tax and customs authorities. The approach described is within the methods allowed in the OECD guidelines, so approval should not be a problem – just timetaking since approval needs to be reached with each individual tax and customs authority individually.

 

Our second client, based in Italy, required a transfer price for movement of components between locations within Italy, so there were no tax implications. The component manufacturing centre is defined as a Value Stream. It was decided to base the transfer price for the next year on the total Value Stream cost (with no corporate overhead allocations) spread across the many different components according to the total machining time on each component over the year. This was fairly easily calculated though it does create a number of difficulties for the lean accountant:

  • It ignores set-up times, downtime, scrap rates and so on, and, therefore, in itself doesn’t encourage lean improvement;
  • It is still a sort of “standard cost” – though at least it avoids corporate allocations.

 

In fact this approach worked quite well because it gave the manufacturing Value Stream the opportunity to make a notional “profit” on the transfer price by improving its performance. A “Value Stream Profit” target could then be set which would help drive further lean improvement. Thus, this approach tends to encourage the improvement of the whole Value Stream rather than trying to take a few machine or labour minutes out of a particular step with no improvement on overall process flow.

 

These methods of transfer pricing work in their own particular circumstances. Your needs may be different, but at least you can be confident that lean accounting gives you the flexibility and the transparency of data to develop and review a range of options and choose the one that works best for you.