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A Study of Transfer Pricing System Practised in Selected Multi-Divisional Organisations in India

Presentation at National Institute of Industrial Engineering
P. C. Basu
December 17, 2003

Proposed Plan for Presentation Acknowledgements Period of Desk & Empirical Survey Emerging Imperatives in Liberalised Environment The Problem Objectives of Research Study Review of Literature TP Determination Practices TPS and Organisation Structure Role of TPS in Delegation of Authority and Motivation TPS and Goal Congruence Conclusions & Recommendation for Future Research

Acknowledgement

Prof. G. Sinha, University of Calcutta; Prof. Michael Bromwich, CIMA Pof. at London School of Economics; Prof. Miles B. Gietzman, London School of Economics;

Distinguished Authors & Academicians of India and abroad;

Officials of Organisations, studied during empirical survey; Libraries of CU, IIM (C), BDHC, USIC, ICAI, ICWAI, ISI, B. L. & Co. Ltd. and National Library, Kolkata; and

Smt. Reba Basu, wife of this presenter

Period of Conducting Survey

Exploratory Desk Survey
Books, Published Literature and Empirical Research Results during 1954 to 1997

Empirical Survey
Twenty-seven Business Organisations in India during 1995 to 1997 (out of sixty-four, identified to be practising Transfer Pricing System)

Administration of Questionnaire & Personal Interview

A set of questions were asked for statistical analysis of responses Nominated Executives were interviewed for detailed study of systems and procedures

Selected Organisations for Empirical Study

Sl. Name of Organisations Fi n. Res ults ,1994-95 (Rs . M ln.) Tur nover 5,731.1 3,998.0 35,082.8 2,425.5 357.9 2,135.1 3,679.7 2,243.6 3,992.8 1,948.2 28,827.0 215.8 840.0 38,100.0 2,000.0 27,680.0 4,151.7 6,710.9 8,034.2 2,341.7 5,011.0 9,244.3 4,120.0 56,831.2 46,499.1 2,529.0 8,184.0 Pr ofi t Cap.Empl. 161.2 (860.0) 3,090.0 210.3 25.3 279.1 32.6 440.5 125.6 107.3 3,027.1 18.4 44.4 2,610.0 * 3,268.6 371.5 141.4 343.1 (6.8) 474.0 2,867.1 760.0 4,514.1 2,811.2 138.5 217.8 3,057.7 1,157.0 23,767.8 1,676.2 77.4 4,604.7 1,476.0 7,541.9 970.3 1,469.5 8,023.6 148.4 339.0 10,430.0 * 27,771.2 4,274.0 5,268.0 2,547.9 1,432.6 2,554.1 25,658.2 3,710.0 25,760.1 62,585.8 2,009.4 4,312.8 No . Balmer Lawr 1 i e & Co. Ltd. 2 Bata I ndi a Ltd. 3 Bhar at Heavy Electr i cals Ltd. 4 Chlor i de I ndus tr i es Ltd. 5 Development Cons ultants Pvt. Ltd. 6 Deepak Fer ti li s er & Petr ochemi cals Ltd. 7 GEC Als thom I ndi a Ltd. 8 Glaxo I ndi a Ltd. 9 Godr ej And Boyce M fg. Co. Ltd. 10 Her di lli a Chemi cals Ltd. 11 Hi ndus than Lever Ltd. 12 I FB Agr o I ndus tr i es Ltd. 13 I on Exchange (I ndi a) Ltd. 14 I . T. C. Li mi ted 15 Johns on & Johns on Ltd. 16 Lar s en & Toubr o Ltd. 17 Lupi n Labor ator i es Ltd. 18 M ukund Li mi ted 19 Phi li ps I ndi a Ltd. 20 Polychem Li mi ted 21 Si emens Ltd. 22 Tata Chemi cals Ltd. 23 Tata Tea Ltd. 24 The Tata Engg. And Locomoti ve Co. Ltd. 25 The Tata I r on And Steel Co. Ltd. 26 Us ha M ar ti nI ndus tr i es Ltd. 27 Voltas Li mi ted
* Being a closely held company did not disclose the data.

Classification of Organisations Studied

22%

11% 7%

60%

Privat Sector Organisations with Foreign Origin

Public Sector Multi-nationals

Background of Study Emerging Imperatives in Liberalised Environment

Business Environment
Yesterday First four decades after independence India kept
her industries insulated from global competition

She evolved her own brand of self-sufficiency Self-sufficiency does not mean inefficiency The inevitable happened The historic process of liberalisation and
integration with the global economy started with the dawn of nineties

Business Environment 2
Today
Exposure to sever global competition. Technology explosion is increasing emphasis on productivity Consumerism, manifold options to choose from Earlier formula of Price = Cost + Pre-determined is being replaced by the market driven reality: Selling Price = Value critically measured by customers for the utility offered Return = Interest, Profit, Capital Appreciation, and Retentions for meeting term liabilities future business expansion. Thus Cost = Residue to be shared by other inputs and hence is the Target for Value Management

Business Environment 3
Tomorrow
Harder time ahead for Enterprise and not Customers Competitive edge will shift from products to technical skill Obsolescence galore Demand for accountability and transparency will redefine the concept of fiscal and corporate governance Disinvestment from and hostile takeover of inefficiently managed units will be inevitable Jobs will revolve around thinking, innovation and creativity Sustained value generation skill and not ownership will be the ultimate criteria for occupying the drivers seat Thus > The new era will be harder for business enterprises and not

Emerging Imperatives
High operating efficiency and effectiveness Dramatic improvement of systems and procedures in terms of: Quality - Product Differentiation Cost - Cost Leadership Service - Customers delight Speed - Respond to changes in market, and environment - Increased turnover of resources Volume - Large enough to achieve competitive advantage

Emerging Imperatives 2
Integration of operation for achieving sustained growth Result focussed design of Organisation Structure

Derive advantages of both large and small spans of operations

Divisionalisation of operation with adequate autonomy Empowerment at the functional level for faster execution Continuous monitoring of operation and responsibility accounting Performance linked compensation and incentives

Orchestration of all operations to achieve harmony

Emerging Imperatives (Contd.)

Where does the Imperatives lead to?
Result focussed design of Organisation Structure Decentralisation through divisionalisation

Simulated decentralisation forms structural units which are not businesses . set up as if they were businesses, with maximum possible autonomy and responsibilities for profit and loss
Peter F. Drucker

Defining divisional interdependence with autonomy to deal with external sources / customers to remove sub-optimalities
Deriving benefits of integrating operations:

Save input costs for the final product Ensure supply of intermediates with 4 Rs Right quantity, Right quality, Right time, Right price Cope with changing technology Improve co-ordination and speed
However, avoid setting-up Pseudo Profit Centres ICMA, London

Therefore the Need has Emerged for Managing Business in a Multi-divisional Environment

Business within Business

The Problem
Divisionalisaion of operation through decentralisation brings in many risky effects
Is Transfer Pricing System an effective tool for neutralising those risky effects?

Risky Effects of Divisionalisation

Managers may tend to forget interest of others in their

urge to maximise his/ her own divisions profitability May become myopic and may not contribute towards optimising companys profitability
Particularly in an integrated operation the second division may

not accept the input from the first division if prices are not competitive Two forces shall operate in reverse directions with given autonomy

Conflicts in interest amongst divisions and Corp. Head

Office
Obstacles in coordination, coherence and harmony for: Allocation of resources Maximising employee motivation and performance Maximising Companys profitability through that of divisions

Risky Effects of Divisionalisation 2

Actions needed to minimise such risks and problems Measures for neutralising conflicting forces

Continuous intervention by a team of dedicated

managers Introduction of effective information and communication system The above actions are expensive and time consuming Continuous human interventions and improvisations may bring in non-standard but conflicting solutions for similar types of problems

The Solution

The Time Honoured Tool

Empirical Researches conducted in various parts of the World and authentic opinions of Renowned Association of Accountants have recommended introduction of

Transfer Pricing System (TPS)

Genesis & Historical Background of Transfer Pricing System

Definitions of Transfer Pricing System

TPS is a tool for assigning a calculated and/or negotiated value in monetary terms to the goods or services while effecting transfer between two related business units. The system is designed with a view to
Motivating the employees Coordinating and controlling activities Congruating organisational goals with those of the units

so that goals of the organisation as a whole are achieved by aggregating the goals of the divisions Inter-relation between business units can exist in a Multi-divisional environment, or Conglomerate environment

Objective of Research Study

Objective of Research Study

1. Assess the extent to which TP method are practised by the selected multi-divisional organisations in India; 2. Know whether or not the attributes of a decentralised organisation structure, necessary for practising TPS prevail; 3. Inquire whether the system of delegating power to the divisional managers is adequate for deriving the benefits of decentralisation through application of TPS; 4. Appreciate the system of performance evaluation in ensuring accountability and employee motivation for the introduction of TPS; 5. Assess the impact of TPS on interpersonal relationships and employee behaviour; 6. Analyse the systems of setting goals for different divisions and the role of TPS in removing the factors which are detrimental to achieving goal congruence; 7. Diagnose the major deficiencies in practising TPS; and 8. Inquire the ways and means of overcoming such deficiencies

How Did They Determine TP ?

Genesis & Historical Background of TPS

Genesis
The genesis of Transfer Pricing System lies in the queries of business owners on financial performance of individual operations.

Research findings:

Even in the 18th century England, cotton mill owners wished to know which were the profitable parts of their business and used Transfer Prices to help identify this
C. Emannuel D. Oteley & K Merchant

Genesis & Historical Background of TPS 2

Historical Background
PCB in his desk-survey for doctoral thesis has found:

Application of Transfer Pricing System, as a tool for management in a multi-divisional environment, gained momentum after World War II.

With explosion of technology and vertical integration of industrial units, TPS evolved as an essential tool for profit optimisation in a multi-divisional environment.
Cross border Transfer Pricing is an extension of the tool to transactions between related parties in a multinational environment. It is a phenomenon of late sixties.

Genesis & Historical Background of TPS

Genesis
Research findings:

Even in the 18th century England, cotton mill owners wished to know which were the profitable parts of their business and used Transfer Prices to help identify this
C. Emannuel D. Otley & K. Merchant

Genesis & Historical Background of TPS 2

Historical Background PCB in his desk-survey for doctoral thesis has found:

Application of Transfer Pricing System, as a tool for management in a multi-divisional environment, gained momentum after World War II.

With explosion of technology and vertical integration of industrial units, TPS evolved as an essential tool for profit optimisation in a multi-divisional environment.
Cross border Transfer Pricing is an extension of the tool to transactions between related parties in a multinational environment. It is a phenomenon of late sixties.

Determination of TP
Parameters for setting targets vis--vis Method of Fixing TP (%) Method of Fixing TP Profitability - Market Price - Negotiated Price Production Efficiency - Cost of Production Corporate Control - Other Methods Total India 1997 25.93 14.81 51.85 U S A 1977 1990 31.50 18.10 50.40 36.70 16.60 46.20 Japan 1977 33.70 19.30 46.20

7.41
100.00

-100.00

0.50
100.00

0.80
100.00

Sources

PCBs Study

R. Y. W. Tang & Tangs Study Walters Study

R. Y. W. Tangs Study

TPS and Organisation Structure

TPS and Organisation Structure

Major Issues Dealt with Changing business environment in India Method of structuring the organisation
Sequence of installing production/ service facilities Reasons for in-house production of Intermediates

Timing of divisionalisation
Interdependencies Coordination Formality and Informality

Role of TPS on Delegation of Authority and Motivation of Employees

TPS and Organisation Structure

Major Issues Dealt with

Delegation of Authority in complex and competitive environment Motivation drives, desires, needs, wishes Relation between TPS, DoA and Motivation Position of DoA and Motivation in selected organisations Extent of interference Level of satisfaction Measurement of accountability - performance evaluation Commitment of employees Role of TPS in motivating employees Impact of TPS in inter-personal behaviour

TPS and Management of Goal Conflicts

TPS and Management of Goal Conflicts

The Issue
When a large number of people get involved in a real life process the end-means chain has to accommodate a variety of needs and motives of different divisions and departments. TPS gives scopes to accommodate the needs and motives
V. S. P. Rao & P. S. Narayan

TPS & Management of Goal Conflicts

Causes of Goal Conflicts
1. Lack of knowledge and understanding about goals of self and others 2. Lack of communication across divisions and corporate office 3. Partiality embedded in systems for rewarding by corporate office

4. Discrimination in resources and facilities for performance

5. Mismatch between divisions in goals and effort levels 6. Lack of adaptability of the organisation structure to the changing business environment

TPS helps resolving all the above issues!

TPS and Management of Goal Congruence

Major Issues Dealt with
Goals and Objectives in a complex and competitive environment

Process, practices and frequency for setting goals

Multiple goals and goal conflicts Goal parameters

Impact of TPS in goal setting

Achievements, rewards and penalties TPS - a means for goal congruence

Major Conclusions
and Recommendation for Future Studies

Major Conclusions
TP Determination System

Selling Division gets scope to reflect operational result

Adequate norms, checks and balances are there in Cost Based Methods to remove effects of inefficiency
Market price is adjusted with savings for in-house procurement

No instance of TPS while transferring intermediates to marketing operation

Multi-stage TPS is there when there are more than two stages of independent production processes

Major Conclusions 2
TPS and Organisation Structure

Integration of operation has helped in profit maximisation Organisation structure has been re-laid to introduce Responsibility Accounting In about 50% cases decentralisation was done concurrently with and in about 33% cases after introduction of TPS

TPS is considered to be essential for decentralisation of operation

TPS helps in coordination of activities and managing interdependencies

Extent of formality observed in the style of management does not hamper the success in adopting TPS

Major Conclusions 3
TPS and Delegation of Authority

TPS helps in management of both involvement and empowerment Adequate independence is there in operation with laid down DoA Divisions are self-contained in about 80% cases Marginal interference in routine matters and about 50% in divisional level strategic matters Complete independence does not guarantee higher success Performance evaluation is done at regular intervals

Major parameters for performance evaluation are ROT and ROI

TPS plays an important role in setting of targets

Major Conclusions 4
Employee Motivation

TPS helps employees in achieving both organisational and personal goals TPS helps in interact more and developing inter-personal relationship Commitment increases 90% opined to have committed employees to both divisional and organisational goals TPS thus helps as a multiplier effect in motivating employees

Major Conclusions 5
Goal Congruence

Goal setting for Turnover, Profit and profitability is dependent upon TPS TPS influences employee behaviour in management of goals In about 70% cases TPS is opined to be of substantial help in settlement of goal conflicts and profit sharing

TPs are not reset if goals are not achieved by any of the divisions
In case of Market Price and Negotiation based TPS, goal congruence occurs automatically

Resolves issues related to allocation of quantity amongst user division and external sales of intermediates
TPS has excellent effect in integration through profit management

Recommendations for Future Research

Why many multi-divisional organisations with have not adopted
TPS as tool for management even if one of the divisions produces intermediates?

Why MP is not adopted by majority of the orgnisations as the TP?

Can TPS help in evaluation of merger and acquisition schemes

Why TP is not fixed with Cost of Production plus Opportunity

Cost?

Why Marketing Function is not treated as a Profit Center?

Thank you very much indeed

TP Determination
Parameters for setting targets vis--vis Method of Fixing TP: 1. Cost of Production a. Marginal Cost of Production With negotiated norms for: - Inputs and Outputs - Productivity - With or without fixing procurement rate for each factor Actual cost of previous year
b. Total Cost of Production (a) plus Fixed Costs i) Actual for the previous year ii) Pre-determined with detailed assumptions iii) Dual Pricing ~ (ii) is allocated at the year end in proportion of internal and external sales

TPS & Setting of Budgetary Targets

Multi-divisional Environment Domestic (Contd.)
Parameters for setting targets vis--vis Method of Fixing TP: 2. Cost Plus Profit

c. Pre-determined profit
With negotiated rate for: - ROCE or ROI percentage - Profit per unit Fixed or percent of COP - Fixed per unit 3. Market Price i) Country average or Regional average ii) With or without adjustments for savings in costs for procurement and selling

iii) List / quoted prices of industry leaders

TPS & Setting of Budgetary Targets

Multi-divisional Environment Domestic (Contd.)
Parameters for setting targets vis--vis Method of Fixing TP: 4. Arms Length Negotiation of TP Fixed for a year / month(s) c.

- With corporate representative as an umpire - Without corporate representative - If fixed for a year with or without clauses for escalation in price for major input(s) at a given input/output ratio - With or without initial bidding
5. Centralised Control - Fixed by Corporate Head Office

a. With strategic imperatives - Internal - External b. Without strategic imperatives control c. With or without participation of representatives from Divisions