Transfer Pricing and Vertical Integration

Overview: Transfer Pricing • Framework and Economic Principles • Cases Considered – – – – No outside market for upstream good Competitive outside market for upstream good Market power in outside market for upstream good Tax considerations • Vertical Integration Decision Making in a Large Firm • Large firms comprised of divisions (small internal firms), each operating relatively independently • How can efficient allocation of inputs/outputs across divisions be achieved? – Centralization : Dictate all quantities & transfers Problem : communication is often prohibitive. – Decentralization : Let divisions decide on quantities and prices Problem : how to make sure local units make decisions that maximize total profits? Adam Smith and Alfred Sloan • Adam Smith’s great insight: – given proper incentives, each individual pursuing his or her self interest maximizes the performance of the economy. – under certain conditions, market prices provide efficient incentives • Alfred Sloan used this insight as a principle of organization within a firm – Divide into divisions (“profit centers”) – Each division maximizes profits Transfer Pricing in a Large Firm • Each division decides on its own production and on its own pricing for external parties, but is also responsible for its own profits. • Terminology : P&L responsibility, BU's, profit centers • This requires a way to value internal transfers (Transfer Pricing) such that divisional profit maximization implies firm profit maximization – Prices set by top management – Issues Optimal Transfers Upstream Division Produces Q Primary Cost C(Q) Q Downstream Division Requires Q as input Net Revenue = NR(Q) • NR(Q) is revenue from Q less cost of processing Q (in downstream division) • Profits of the firm, in terms of Q, are Π = NR(Q) - C(Q) • What is the profit maximizing level of Q? .... (Drum roll ...) MC(Q) = NMR(Q) Divisional Profit Maximization • Q is priced at p for internal transfers. • Upstream Division: – Revenues = p Qu, Costs = C(Qu) – (Internal) Profits Πu = pQu - C(Qu) – Maximizing: Produce Qu such that p = MC(Qu) • Downstream Division: – Revenues = NR(Qd), Costs = p Qd – (Internal) Profits Πd = NR(Qd) - pQd – Maximizing: Order Qd such that p = NMR(Qd) Setting the Transfer Price • Optimal Transfer Price: p* such that Qd = Qu • We have p* = MC(Qu) = NMR(Qd) – If wrong transfer price set, either • Qd > Qu • Qd < Qu (shortage of input) (surplus of input) – Much easier to set transfer price with competitive outside markets (follows after example) Graphically Downstream Profits (No FC) MC (upstream) Optimal transfer price p* Upstream Profits (No FC) NMR (downstream) Q (produced and processed) Internal Optimal Transfer Pricing (No Outside Market) Example: Firm makes chips & computers (e.g. Apple and the 3 GHz chip) • Upstream division makes chips • Downstream divisions assembles computers • Data: – Upstream: Chip Manufacturing Plant: Q is # of chips in thousands • Total Costs: TCu = Q2 ==> MCu = 2Q – Downstream: Computer Manufacture • Need one chip per machine (Q also represents # computers) (Firm monopolizes their demand) • Demand: P = 4000 - 4 Q • Assembly Costs (all costs except the chip) = 1500 Q: ==> MCa = 1500 Example: continued • NMR is “Demand for Chips” from downstream division R = PQ = (4000 - 4 Q)Q NR = (P - MCa)Q = (2500 - 4 Q)Q NMR = 2500 - 8 Q • Optimal chip production has NMR = MCu NMR = 2500 - 8 Q = 2 Q = MCu 2500 = 10 Q Q = 250 • Transfer Price: p = 2(250) = 500 (= MCu) Example: continued • Profits: Upstream Division: pQ - TCu = 500(250) - (250)2 = 62.5 m Downstream Div: NR - pQ = 1500(250) - 500(250) = 250.0 m Total Company Profits = 62.5 m + 250 m = 312.5 m (Note how transfer revenue/cost cancels out) Various Issues • If there are many divisions, do we need new principles for transfer pricing? • What if there are outside sources of the chip? • Why does each division’s internal “profit” matter? • Are there tax considerations? • Does market power matter? Multiple Sources or Uses 1. Multiple Sources: C1(Q1) NR(Q1+Q2) M C2(Q2) Optimal Transfer Price: p* = MC1(Q1) = MC2(Q2) = NMR(Q1+Q2) 2. Multiple Uses: NR1(Q1) M1 NR2(Q2) M2 C(Q1+Q2) Optimal Transfer Price: p* = NMR1(Q1) = NMR2(Q2) = MC(Q1+Q2) Application: Competitive Outside Market • Competitive Outside Market – You can buy Q at price p (market is a source) – You can sell Q at price p (market is a use) – Set transfer price p* = p, market price P M1 (competitive) C(Q1+Q2) P NR2(Q2) M2 • Easiest Case: No calculation required – Transfer price = market price (end of story) Graphically MC (upstream) Additional Profit Tr. Price w/o market p (market price) Opt transfer price p* NMR (downstream) Q produced upstream Q bought outside Effective MC from upstream division and market Back to the Example Suppose there is a substitute chip available for $ 350 • So ………… Set transfer price p = 350 • Upstream (chip) division produces so that p = MCu, or 350 = 2Q, or Q = 175 • Downstream (computer) division orders chips until p = NMR, or 350 = 2500 - 8 Q, or Q = 268.75 • So, 175 (thousand) produced, 93.75 purchased outside, 268.75 computers made. • Profits = NR(268.75) - TC(175) - 350(93.75) = 319.5 m • Note: 319.5 m > 312.5 m ; 7 m additional profit Application: Outside Market Power • You monopolize an outside market for intermediate product (M1) P M1 C(Q1+Q2) P* NR2(Q2) M2 • With market power, p* = MRoutside < ARoutside => p* < p, the outside market price for intermediate product • Summary: Transfer at MC; the outside market price p is higher than transfer price p*. Divisional Profits and Evaluation • Internal Profits add to Firm Profits • Are division profits useful for evaluating performance? – It depends: Can reflect efficiency gains in production – Yes, with outside competitive market • Raises bargaining issues for prices – Increased p raises upstream profits, lowers downstream profits – This is one reason p is set by top management • If a division can set p, losses typically result – Double Marginalization Double Marginalization Downstream Profits Downstream Profits Loss to Firm Loss to Firm MC MC p p Upstream Profits Upstream Profits NMR Q Upstream Division Sets Transfer Price NMR Q Downstream Division Sets Transfer Price Back to Example Suppose Upstream (chip) division sets price. • NMR is “Demand for Chips” from downstream division NMR = 2500 - 8 Q, so Chip Revenue = CR = (2500 - 8Q) Q • Upstream Profit Max: produce chips until MCR = MCu MCR = 2500 - 16 Q = 2Q = MCu 2500 = 18 Q Q = 138.9, Transfer Price = 2500 - 8 (138.9) = 1388.9 • Profits: – Upstream Division: pQ - TCu = 173.7 m > 62.5 m – Downstream Division: NR - pQ = 77.1 m < 250 m – Total Company Profits = 173.1 m + 77.1 m = 250.8 m < 312.5 m • 61.7 m lost due to bad management of transfers Tax Avoidance • Suppose your divisions are located in different countries, with different tax rates. • Separate books for taxes and for management – Legal limits on what can be reported for taxes • Can adjust transfer prices to “move” profits from high tax countries to low tax countries – WSJ article for many examples Tax Avoidance • High tax for downstream division suggests raising transfer price, raising downstream costs and lowering downstream profits • With common books, tradeoff between efficient production and tax avoidance Notes on Vertical Integration • Wrong arguments for vertical integration • Reasons for vertical integration • Costs of vertical integration Wrong Arguments for VI • Capture profits of suppliers – Need compensation for extra UCC – Future economic profits will be reflected in acquisition price • Protect against price rises – Price rises are reflected in opportunity cost Reasons for Vertical Integration • • • • • • Transaction cost economics (TCE) Hold-up Externalities and synergies Information flows stay within the firm Ability to decide on incentives Price discrimination Costs of Vertical Integration • Market discipline (competition) gives strong incentives. • Non-integration maximizes flexibility and improves matching. Take Away Points • Transfer pricing brings the market in the firm and allows the creation of profit centers. • The optimal transfer price equals the marginal cost. • With competitive outside market, transfer price equals market price. • Transfer prices have tax implications. Separate tax and internal books are typical. • Integration is a complex trade-off. Always consider contracting as an alternative.