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

strategy  Decentralized cost & profit center

 Cost systems : variable cost & fixed cost
TEVA PHARMACEUTICAL
INDUSTRIES LTD.
Marketing >< Operation

Transfer Pricing System based on Marginal cost = material cost

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
 What everyone wanted ?
(The characteristics of transfer pricing systems)
 consistent with long-run profit
 distinguish costs relevant for short-run & long-run
Senior decisions
Management  support marketing decisions : product mix, new product
introduction, product deletion, pricing
 support operations decisions : inventory levels, batch
size, process improvements, capacity management,
outsourcing

Division Financial performance fairly, scope of authority, decision

of marketing div. would reflect both sales revenue &
Manager
associated expense in operation div.

Financial Credible & relied at all level organization; to be clear, easy

Staff to explain & use.
 TRANSFER PRICE APPROACHES

 TRADITIONAL METHODS
 No feasible
a. Market price
 No capture the actual cost
b. Full cost considered
structure
c. Marginal cost but rejected  inadequate for their purposes
d. Negotiated price  consume excessive time on
nonproductive discussions

 ACTIVITY-BASED COSTING METHODS

Calculating the activity This information are defensiable, &

costs, activity cost driver quantifiable answer to a question about
rates, & product cost for how much it cost to manufacture a
the prior year special small batch for a customer.
 THE ABC TRANSFER PRICE MODEL STRUCTURE

 UNIT COSTS The direct expenses associated with producing

individual product unit, include the cost of raw
materials, packaging materials, & direct wages
paid to production workers.

 BATCH-LEVEL The expenses of resources used for each

COSTS production or packaging batch, mainly the
costs of preparation, setup, cleaning, QC,
laboratory testing, computer & production
management.

 PRODUCT The expenses incurred in registering the

products, making changes to a product’s
SPECIFIC COSTS
production processes, & designing the package.

The cost of maintaining the capacity of

 PLANT-LEVEL production lines depreciation, inspection,
COST 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.
ABC Transfer
Pricing System Led to a dramatic reduction conflict
among marketing & manufacturing
managers.
 What is EVA, and How Can It Help Your Company

Combine the concept of residual income

Economic Value with principles of modern corporate
Added (EVA) finance, that all capital has a cost and
that earning more than the cost of capital
creates value for shareholders.

Profits from company’s operation after tax

NOPAT
before financing cost & noncash-booking
minus (-)
Cash flow required to compensate
Capital
investors for the riskiness of the business
charge
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.

calculated
MVA (+) :

MVA = [(shares outstanding x stock price) shareholder richer

+ market value of preferred stock + market
value of debt] – total capital MVA (-) :
Shareholder wealth
has been destroyed
 Two Methods of Calculating a Firm’s EVA

FINANCING APPROACH :

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.

result :
 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.
 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,

Using both EVA &
managers also should focus on MVA,
MVA allows to account
because MVA is constructed off the for both year-to-year &
market value of firm’s securities, it long-term changes in
reflects the market’s expectations of value.
future opportunities.
 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. Basic means of raising
• Use less capital. company’s EVA
• Invest capital in high-return projects.

BENEFITS OF EVA INCENTIVE PLANS

EVA-based Employees to be Focus on

incentive plan be entrepreneurial, to creating value
implemented think & act owners. of the firm.

Revise the Bonuses & Improve a

compensation
pay schemes firm’s MVA
systems
 “GREENING” WITH EVA

 EVA considers the cost of

EVA different with all capital (debt & equity).
conventional measures
 EVA is not constrained by
GAAP.
calculating :

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

MVA = Market value – Invested capital related EVA

 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
STEP 1 : STEP 3 :
Establish buy-in at the board & top The steering committee formulates a strategy.
management levels What functions will be tied to EVA ?
Compensation
STEP 2 : Strategic planning
Operating budgets
Set up a steering committee that
Capital budgets
will make the major strate decisions
Investor relations
on the EVA program (subject to
How far down the hierarchy will EVA be
board approval)
calculated ?
How will EVA be calculated ?
STEP 4 :
Management Compensation
The steering committee appoints a Who will be covered ?
working committee to implement How will the bonus plan work ?
the strategy. Relation to nonfinancial measures

STEP 5 : Set up a training program.

 EVA AND FINANCIAL MANAGEMENT

EVA is innovative in three important ways :

• 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, CAPITAL INVESTMENT DECISIONS, AND
ENVIRONMENTAL IMPACTS

General
capital The quality of capital
investment investment decisions

COMPANY
Products, services,
& activities
Environmental
issues considering
resolved EVA
The board lifecycle
Health & safety communicated impact in long-term
corporate profitability
The potential contribution of (life of investment)
project with consistent language
 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.