Use weighted averages to determine transfer pricing.(selected topic)

How should companies price goods that they ship between their own divisions or related companies?

Internationally that quandary confronts the producers of nearly hall of all U.S. imported goods, a third of all U.S. exports, and a huge proportion of global trade elsewhere. By definition these aren't arms-length deals in an open marketplace, and they raise tough questions. What price, for instance, might Ford of Germany charge a Ford division in Mexico for German-made engines that are installed in Mexican-assembled cars?

Hirshleifer's approach does not take account several complicating factors that are pervasive in multinational corporations: differences in corporate income taxes and limited knowledge by the firm's central management. For example, corporate income taxes are higher in Germany than in Mexico. Ford might want, then, to put a low transfer price on its German-built engines in order to produce lower taxable profits in Germany and higher ones ill Mexico. But managers in Germany might feel cheated when their bonuses suffer with the German division's profits. They might reduce emphasis on producing these export engines.

In a prize-winning research paper, Stefan Reichclstein, the William R. Timken Professor of Accounting at the Stanford Graduate School of Business, with co-authors Tim Baldenius and Nahum Melumad, both of Columbia University, have developed a real-world answer to transfer pricing that balances both the economic criteria confronted by Hirshleifer and the puzzle of international tax rates." Integrating Managerial and Tax Objectives in Transfer Pricing," published in The Accounting Review, concludes that a relatively simple weighted average is the management optimum for transfer prices. The conclusion, arrived at through a series of mathematical models, promises a new management tool for thousands of firms around the world that confront these problems.

For the moment, most companies determine a single set of transfer prices, driven primarily by the goal of minimizing overall corporate taxes. The authors contend that approach has ignored other hugely important areas, from management incentives in foreign divisions to "allocation of production capacities and guidance for future capital investment.

"Transfer pricing has been a somewhat neglected area," says Reichelstein in an interview. "People recognize that this is a big issue, but what most people think about is transfer pricing as a tax optimization issue,' he says. "Yet, transfer prices are management tools .They have an important function to facilitate decisionmaking, to tell certain regional or country managers what the value or price of some intermediate product is and use that information to maximize the profit of the company as a whole. That is the economic function of transfer pricing."

The ...