Transfer pricing

Case study :

• Glaxo-Smithkline – between US and UK• Compaq Computer corporation- US and

Singapore• Seagate Technology Inc.- US and Singapore

Glaxo-Smithkline(1999)

• GSK was charged for misappropriating profits and avoid paying taxes in US.

• GSK had its HQ in USA and operating companies in 70 and products sold in 191 countries

• In 1995, Glaxo Wellcome group was created. It later merged with SmithKline Beecham.

• Drugs like Zantac, Zofran, Ceftin earned a lot of revenue. However, once the drugs were researched and developed they were cheap to manufacture.

• The R&D was done in UK while the US arm was responsible for sales. The IRS contended that Glaxo had overvalued their cost of research and development in the UK and undermined the marketing costs in US

Compaq

• Largest manufacturer of PC in 1994• In 1999, they were served tax deficiency

notice by USA .• This related to transactions between Compaq

US and its subsidiary in Singapore (Compaq Asia) for the purchase of printed circuit assemblies

• Compaq had three sources to meet its PCA requirements.

• Compaq Asia, contractors in the US and Compaq US

• Compaq Asia sold PCA to Compaq USA at an average transfer price that was equal to 93.9% of the Compaq US standard costs for 1991-92.

• Given the low cost of manufacturing in Singapore , this was not accepted by the IRS.

• Compaq justified its cost plus pricing by by resorting to Comparable Uncontrolled Price method

• Compaq won the case

Seagate Technology INC

• Founded in 1979, it was a world leader in designing, manufacturing and marketing of hard discs

• Seagate Singapore began selling component parts for disc drives to Seagate US.

• IRS claimed that royalty payments made by Seagate Singapore to Seagate US were not enough.

• Pricing component parts. • Seagate Sing. also sold to other companies

such as Bull Peripheriques and earned similar profits as with its sales to the parent company. However lack of data did not convince the IRS.

• Pricing disc drives- Seagate could not convince that that they paid Singapore subsidiary excessive prices for disc drives.

Break Even Point

• A calculation of the sales volume (in units) required to just cover costs. A lower sales volume would be unprofitable and a higher volume would be profitable. Break-even analysis focuses on the relationship between fixed cost, variable cost (or cost per unit), and selling price (or selling price per unit).

• The sales volume (express as units sold) at which the company breaks even. Profits are $0 at the break even point. The break even point is calculated by the following formula:

• Break Even Point = Fixed Costs / (selling price-variable costs).

• The Break Even Point is expressed a the number of units, over a specific time period, that must be sold to obtain a Net Profit of $0. The time period the units must be sold is always the same as the time period of the fixed costs.

• Break Even Calculator Example• Assume the following:• Fixed Costs: Monthly Rent $100• Insurance ($600 per year $600/12 months = $50) $50 • Total Monthly Fixed Costs $150 • Variable Cost: • Materials $3 • Labor $4 • Total Variable Cost $7 • Selling Price: $10•

Break Even Point Calculation Break Even Point = Fixed Costs / (selling price - variable costs)

• Break Even Point = $150 / ($10-$7)• Break Even Point = $150 / $3 • Break Even Point = 50

To break even the company must sell 50 units per month.

Break-Even Analysis

Costs/Revenue

Output/Sales

Initially a firm will incur fixed costs, these do not depend on output or sales.

FC

As output is generated, the firm will incur variable costs – these vary directly with the amount produced

VC

The total costs therefore (assuming accurate forecasts!) is the sum of FC+VC

TCTotal revenue is determined by the price charged and the quantity sold – again this will be determined by expected forecast sales initially.

TR The lower the price, the less steep the total revenue curve.

TR

Q1

The Break-even point occurs where total revenue equals total costs – the firm, in this example would have to sell Q1 to generate sufficient revenue to cover its costs.

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VC

TCTR (p = £2)

Q1

Loss

Profit

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VCTCTR (p = £2)

Q1

If the firm chose to set prices lower (say £1) it would need to sell more units before covering its costs

TR (p = £1)

Q3

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VCTCTR (p = £2)

Q1

If the firm chose to set price higher than £2 (say £3) the TR curve would be steeper – they would not have to sell as many units to break even

TR (p = £3)

Q2

Break-Even AnalysisCosts/Revenue

Output/Sales

FC

VC

TCTR (p = £2)

Q1 Q2

Assume current sales at Q2

Margin of Safety

Margin of safety shows how far sales can fall before losses made. If Q1 = 1000 and Q2 = 1800, sales could fall by 800 units before a loss would be made

TR (p = £3)

Q3

A higher price would lower the break even point and the margin of safety would widen

• Determining the Break-Even Point – Example

Break-Even Analysis

• Remember:• A higher price or lower price does not mean

that break even will never be reached! • The BE point depends on the number of sales

needed to generate revenue to cover costs – the BE chart is NOT time related!

Break-Even Analysis

• Importance of Price Elasticity of Demand:• Higher prices might mean fewer sales to break-even

but those sales may take a longer time to achieve.• Lower prices might encourage more customers but

higher volume needed before sufficient revenue generated to break-even

Break-Even Analysis

• Links of BE to pricing strategies and elasticity• Penetration pricing – ‘high’ volume, ‘low’ price –

more sales to break even• Market Skimming – ‘high’ price ‘low’ volumes –

fewer sales to break even• Elasticity – what is likely to happen to sales when

prices are increased or decreased?

example• Sales were Rs 15,000 and profits were Rs 400 in a

week. In the next week, sales were 19,000 and profit = 1200. Increase in the variable costs = 3200.

• Find BEP• VC Per rupee of sales= 3200/4000 = .8• Contribution margin ratio = S-V/ S = 15000-

12000/15000 = 0.2• BEP = FIXED COSTS/ CONTRIBUTION MARGIN

=2600/0.2 = 13000

Uses of Break-Even Analysis

• Safety margin = {(sales – BEP)× 100}/ Sales• Volume needed to attain target profit target sales = (fixed costs + target profit)/

contribution margin per unit• Change in price Q(NEW)= (FC + P)/SP(new)- VC• Change in costs: SP(new) = SP + VC (new)- VC• To expand capacity or not.

• Effect of alternative prices• Drop and/or add situation• Make or buy decision• Equipment selection• Production planning