TRANSFER PRICING SYSTEM

Transfer Pricing With ABC

Here’s the strory of how a multinational pharmaceutical company solved its transfer pricing problems by using activity-based costing.(by Robert S. Kaplan, Dan Weiss, and Eyal Desheh)

What is EVA, and How Can It Help Your Company

Economic value added (EVA) and market value added (MVA) are not just performance metrics used to rank companies for investors – they can be used to manage your company better. (by Paul A. Dierks, CPA; and Ajay Patel)

“Greening” With EVA

Now you can use Economic Value Added and other shareholder value measures to improve your corporate capital investment decisions. (by Marc J. Epstein and S. David Young)

Transfer Pricing With ABC

TEVA PHARMACEUTICAL INDUSTRIES LTD.

Decentralized cost & profit center Cost systems : variable cost & fixed cost

strategy

Transfer Pricing System Marginal cost = material costbased on

a strom of controversy :

1. Extremely high profit the materials costs only to be charged

2. The operation would get “credit” only for the expenses of purchased materials

3. Less efficient than outside manufacturers no incentive to shift their source of supply

4. Using only a short-run contribution margin approach would not solve the problems caused by treating the marketing divisions as revenue centers

Marketing >< Operation

What everyone wanted ?(The characteristics of transfer pricing systems)

Senior Management

consistent with long-run profit

distinguish costs relevant for short-run & long-run decisions

support marketing decisions : product mix, new product introduction, product deletion, pricing

support operations decisions : inventory levels, batch size, process improvements, capacity management, outsourcing

Division Manager

Financial performance fairly, scope of authority, decision of marketing div. would reflect both sales revenue & associated expense in operation div.

Financial Staff

Credible & relied at all level organization; to be clear, easy to explain & use.

TRANSFER PRICE APPROACHES

TRADITIONAL METHODS

a. Market price

b. Full cost

c. Marginal cost

d. Negotiated price

considered but rejected

No feasible

No capture the actual cost structure

inadequate for their purposes

consume excessive time on nonproductive discussions

ACTIVITY-BASED COSTING METHODS

Calculating the activity costs, activity cost driver rates, & product cost for the prior year

This information are defensiable, & quantifiable answer to a question about how much it cost to manufacture a special small batch for a customer.

THE ABC TRANSFER PRICE MODEL STRUCTURE

UNIT COSTS

BATCH-LEVEL COSTS

PRODUCT SPECIFIC COSTS

PLANT-LEVEL COST

The direct expenses associated with producing individual product unit, include the cost of raw materials, packaging materials, & direct wages paid to production workers.

The expenses of resources used for each production or packaging batch, mainly the costs of preparation, setup, cleaning, QC, laboratory testing, computer & production management.

The expenses incurred in registering the products, making changes to a product’s production processes, & designing the package.

The cost of maintaining the capacity of production lines depreciation, inspection, insurance, security, & landscaping.

USING ABC COSTS FOR TRANSFER PRICING

Price are set for coming year based on budgeted data. Calculate standard activity cost driver rates for each activity. These cost get charged to products based on the actual quantity

of activities demanded. Eliminates monthly or quarterly fluctuations in product cost

caused by variations in actual spending, resource usage, & activity levels.

Ongoing Benefits from ABC Transfer Pricing System

Investment in new production line can be assessed by simulating production cost.

Transfer pricing systems motivates cost reduction & production efficiencies in the manufacturing plants

ABC information helps managers determine which manufacturing facility is appropriate for different types of products.

ABC information is being used to determine operating strategy.

The best news : Harmony is growing

The ability to measure profit performance under changing organizational structures.

Led to a dramatic reduction conflict among marketing & manufacturing managers.

ABC Transfer Pricing System

What is EVA, and How Can It Help Your Company

Economic Value Added (EVA)

Combine the concept of residual income with principles of modern corporate finance, that all capital has a cost and that earning more than the cost of capital creates value for shareholders.

NOPAT

minus (-)

Capital charge

Profits from company’s operation after tax before financing cost & noncash-booking

Cash flow required to compensate investors for the riskiness of the business given the amount of capital invested

cost of capital x capital

What is Market Value Added (MVA) ?

MVA :

A cumulative measure of corporate performance that looks at how much a company’s stock has added to (or taken out of) investor’s pocketbooks over its life & compares it with the capital those same investors put into the firm.

MVA = [(shares outstanding x stock price) + market value of preferred stock + market value of debt] – total capital

calculated

MVA (+) :

shareholder richer

MVA (-) :

Shareholder wealth has been destroyed

Two Methods of Calculating a Firm’s EVA

builds up to the rate of return on capital from standards return on equity in three steps : eliminating financial leverage, eliminating financing distortions, & eliminating accounting distortions.

NOPAT is a sum of returns attributable to all providers of funds to the company,

NOPAT return is completely unaffected by the financial composition of capital.

FINANCING APPROACH :

result :

Two Methods of Calculating a Firm’s EVA

OPERATING APPROACH :

starts by deducing operating expenses – including depreciation – from sales, but other noncash-bookkeeping entries are ignored.

Equity equivalent (EE) reserve adjustments are made,

Interest expense is ignored, because it is a financing charge, but other (operating) income is added to get pretax economic profits (NOPBT).

Equity equivalents :

Adjustments that turn a firm’s accounting book value into “economic book value, which is a truer measure of the cash that investors have at risk in the firm & upon which they expect to accrue some returns”

CRITICISMS OF EVA & MVA

EVA does not account for real options (growth opportunities) inherent in investment decisions.

Market value of securities reflect market’s perception of the value of those growth opportunities, but EVA does not reflect this information.

Firms with fewer assets in place & substantial growth opportunities, year-to-year changes in EVA are less likely to explain changes in firm value.

To capture the growth opportunities, managers also should focus on MVA, because MVA is constructed off the market value of firm’s securities, it reflects the market’s expectations of future opportunities.

Using both EVA & MVA allows to account for both year-to-year & long-term changes in value.

USING EVA & MVA WITHIN A COMPANY

• EVA is adapted to this kind of situation that focuses of creating shareholder value how capital is used & cash flow generated.

• Focusing on EVA growth provides two benefits : 1. Management’s attention is focused to increasing investor wealth. 2. Distortion caused by using historical cost accounting data are reduced or eliminated.• EVA can be used to hold management accountable for all economic

outlays that appear in the income statement.• EVA creates a common language for making decisions (especially

long-term), resolving budgeting issues, evaluating performance units & managers, & measuring the value-creating potential of its strategic options.

• EVA is linked strongly to share price performance & in conjunction with MVA, provides a meaningful target to pursue for internally & externally decisions.

USING EVA TO FACILITATE THE MANAGEMENT OF COMPANY

• Raise profit levels without raising the amount of capital spent.

• Use less capital.

• Invest capital in high-return projects.

Basic means of raising company’s EVA

BENEFITS OF EVA INCENTIVE PLANS

EVA-based incentive plan be implemented

Employees to be entrepreneurial, to think & act owners.

Focus on creating value of the firm.

Revise the compensation systems

Bonuses & pay schemes

Improve a firm’s MVA

“GREENING” WITH EVA

EVA different with conventional measures

EVA considers the cost of all capital (debt & equity).

EVA is not constrained by GAAP.

EVA = Net sales – operating exp. – taxes – capital charges

calculating :

MVA = Market value – Invested capital EVArelated

MVA is the present value of the firm’s expected future EVA.

EVA generates more attention than MVA, because its more amenable to periodic performance measurement.

IMPLEMENTING EVA

Establish buy-in at the board & top management levels

STEP 1 :

STEP 2 :

STEP 3 :

Set up a steering committee that will make the major strate decisions on the EVA program (subject to board approval)

The steering committee formulates a strategy.What functions will be tied to EVA ?CompensationStrategic planningOperating budgetsCapital budgetsInvestor relationsHow far down the hierarchy will EVA be calculated ?How will EVA be calculated ?Management CompensationWho will be covered ?How will the bonus plan work ?Relation to nonfinancial measures

STEP 4 :

The steering committee appoints a working committee to implement the strategy.

STEP 5 : Set up a training program.

EVA AND FINANCIAL MANAGEMENT

• Its users are willing to make whatever adjustment are needed to produce more economically valid numbers, because EVA no GAAP.

• Proponents have been pushing companies to bring EVA into lower levels of the organization on the assumption that all employees must undertake their tasks with the overriding goal of creating shareholder value.

• EVA offers a means of measuring & communicating performance that can be used in capital markets, for capital investment appraisal, & in the evaluation & compensation of managerial performance.

EVA is innovative in three important ways :

EVA, CAPITAL INVESTMENT DECISIONS, AND ENVIRONMENTAL IMPACTS

COMPANY

The quality of capital investment decisions

Products, services, & activities

The board lifecycle impact in long-term corporate profitability (life of investment)

considering

General capital investment

Environmental issues

Health & safety

EVAresolved

The potential contribution of project with consistent language

communicated

BARRIERS AND CHALLENGES TO EVA IMPLEMENTATION

• A full commitment from top management (CEO), not only must the value creation philosophy be integrated with all company’s key systems, but it must constantly be reinforced in management meeting, training, seminar, newsletter, performance review, & communication with external.

• A decision on which, if any, adjustments are to be made the GAAP-based accounting numbers.

• A careful consideration of transfer pricing & overhead allocation policies & their impact on EVA calculations.

• Intensive training for any manager or employee whose bonuses will be linked to EVA.