UNDERSTANDING TRANSFER PRICING

Transfer pricing is the general term for the pricing of cross‐border, intra‐firm transactions between related parties. “Transfer pricing” therefore refers to the setting of prices at which transactions occur involving the transfer of property or services between associated enterprises, forming part of an MNE group.  These transactions are also referred to as “controlled” transactions, as distinct from “uncontrolled” transactions between companies that, for example, are not associated and can be assumed to operate independently (“on an arm’s length basis”) in reaching terms for such transactions.    

In simple terms transfer pricing is the price at which related parties are assumed to transact, and if this price is subjected to tests, it is the same price at which independently trading companies would have transacted.

A simple explanation of transfer pricing is given below.

There is company A Inc which is incorporated in Turkey manufacturing shoes. The same company forms a subsidiary company B Inc in Uganda and it distributes the manufactured shoes in Uganda and East Africa.

Company A inc incurs a cost of production for one pair shoes of $150, however it has set a transfer price of $200 for each pair of shoes it sends to B Inc. Company B Inc also incurs additional operational costs of $50 per pair. The question is what would be the selling price of company A Inc and what cost should Company B Inc declare in its books of account?

Under normal circumstances Company A Inc would have a selling price of $200, and company B Inc would have total cost of $250, however since these companies are trading under controlled conditions, since the actions of company B Inc in Uganda are controlled by Company A Inc in Turkey, the selling price of $200 should be subjected to tests to see if an independent company would sale the same product (Shoes) to company B Inc at the same price.

Secondly since these companies are essentially the same, the shoes should be transferred to Company B Inc incorporated in Uganda at $150 and therefore the cost of production would be $200 and not $250.

For tax purposes to allow the transfer price it must be subject to tests to remove the effects of “arm’s length” transactions. Many companies have been involved in aggressive tax planning and taken advantage of multi-national trade to use the availability of differing tax treatments to reduce their tax obligations and also to pay as little tax as possible.

For example: let’s assume Turkey has an income Tax rate of 20% and Uganda has a tax rate of 30%. Under this assumption it is advantageous if more profits are apportioned to the parent company since the tax rate is low, and low profits in Uganda since the tax rate is high. How is this possible? The parent company A Inc would have to transfer products and services at high prices to B Inc in Uganda, so that they can reduce the effect of tax exposure due to the high tax rate.

For example A Inc sends 100 shoes to B Inc. The other costs of A include License Fees $200.

The Profit and Loss Account for A Inc the parent Company in Turkey would look like this at the transfer price of $200.

ItemUnitTotal ($)
Sales$200*10020,000
Cost of production$150*10015,000
Gross Profit 5000
Less: operating Expenses 200
Profits 4,800
Tax @ 20% 960
Total EAT 3,840
The Accounts of B Inc the subsidiary incorporated in Uganda receiving shoes at the transfer price of $200 with a selling price of $300 and operational costs of $50 per pair of shoes
ItemUnitTotal ($)
Sales$300*10030,000
Cost of production$20*10020,000
Gross Profit 10,000
Less: operating Expenses$50*1005,000
Profits 5,000
Tax @ 30% 1,500
Total EAT 3,500
If Company B Inc was to use the transfer price of $150, incurring operational costs of $50 per pair of shoes and having the same selling price of $300, this would be the effect.
ItemUnitTotal ($)
Sales$300*10030,000
Cost of production$150*10015,000
Gross Profit 15,000
Less: operating Expenses$50*1005,000
Profits 10,000
Tax @ 30% 3,000
Total EAT 7,000
Performance Report of A Inc.
ItemsTaxEAT (Earnings After Tax)
Transfer price to B Inc of $2002,4607,340
Transfer price to B Inc of $1503,96010,840

From the workings above, it is very clear that A Inc incurs a high tax exposure in Uganda; therefore what it would do is to ensure that it maximizes sales in Turkey and apportions more costs and costs of production to B Inc in Uganda so that the tax exposure is reduced. Therefore instead of setting a transfer price of $200 it can set a price of $400 so that profits are maximized in Turkey and reduced in Uganda yet the actual trading of goods, the actual value is added at the distribution level that is in Uganda which distributes the shoes to the final consumers and retailers.
Conclusion
Under OECD each company is taxed independently and it is very important that the Revenue Bodies carry out transfer pricing audits to verify the arm’s length principle in the transfer of services, products and rights among related companies of Multi National Enterprises (MNE).

LEAN MANAGEMENT AS A TOOL FOR BUSINESS RECOVERY FROM ECONOMIC DEPRESSION

Lean or Lean management is a business approach for maximizing customer value while minimizing waste. It is based on the principles of the Toyota Production System (TPS) and aims to create a culture of continuous improvement in an organization. 
 
The main goal of Lean management is to improve efficiency and effectiveness by reducing the time spent on non-value-adding activities and optimizing the flow of work. 
The Lean concept can be successfully applied to any business or production process, from manufacturing to healthcare, engineering, and software development. 

Lean is based on five (5) principles that govern its implementation and its application, the five principles of lean management include:

  1. Defining value
  2. Mapping the value stream
  3. Creating flow
  4. Using the pull system
  5. Pursuing perfection.

We will go through each of these and see how businesses can use lean management as an effective tool for recovery, especially now that different economies are trying to recover from the gross negative effects caused by the Covid-19 pandemic.

Organizations need to optimize activities which produce value, and element any waste so that they can give quality products and services to their customers. Lean management is all about creating value for the customer and reducing waste in the organization

DEFINING VALUE:

This involves the organization understanding what value means in the eyes of the customer, they need to get feedback from their customers about what adds value and what does not add value. For example; a consultancy firm that offers consultancy services needs to find out what the clients want, is it timeliness in execution of projects?, quality advice (data based)? 

Value has been defined as anything that exceedingly brings satisfaction to a consumer of a product or services; value has also been defined as the ability for a product to satisfy the needs of the end user.

Organizations need to focus on the value adding process and qualities that the customers want, so that they do not waste money in making products that are not needed or coming up with innovations that have no value for the customers. This information can be got through interviews, requesting for feedback from clients on the services provided and on the products they consume. It is very important that organizations concentrate only on those items and innovations that add value.

With the scarcity of resources as companies recover from the effects of the pandemic, it is very important that companies concentrate on things that will add value to their customers and cut out any non-value adding processes or items on the products that they make.

MAPPING THE VALUE STREAM

The second principle of lean is mapping out value in the organization’s processes, insight of what has been defined as value from the customers’ view. The organization need to redesign their processes from the view point of the customer.

Two critical types of waste come out clearly at this stage; value adding and necessary, and non-value adding and un-necessary waste. At this stage companies need to totally eliminate the non-value adding and un-necessary waste in their processes or from the products they make, this will also help to reduce the un-necessary costs of production.

An example;  after interviewing their customers, a brewing company finds out that 85% of respondents showed that they do not like the new brand of beer that is being produced, and from the market survey the company also further finds out that the sales for that particular brand are lower than the actual costs of production, it would be reasonable that this particular brand is removed from the production line, over the years we have seen numerous brands of beer dropped by different brewing companies.

It is imperative that companies use this similar approach to drop all non- value adding processes and items which are just waste and non-productive waste. In the next article we will give a detailed explanation and break down of the various wastes that the different organizations have and need to eliminate.

CREATE FLOW

After identifying the waste and eliminating it, the next process is to create systems, processes, and work flows to ensure that waste is not brought back into the production system or way of work. This can be through making SOPs that clearly define how a certain task should be accomplished, training staff and showing them where waste is and waste is, clear guidelines should be made to ensure that everyone in the organization knows what to do, how to do it and when to do it.

Creating flow goes a long way to ensuring that costs are controlled and quality is maintained. It is through this that controls are maintained at the work place and in organizations. Without controls in place, it is very likely that everyone will be doing whatever they want and this can be very costly to the organization in terms of costs, quality of products and organization brand. 

ESTABILISH A PULL SYSTEM

Inventory is considered one of the biggest wastes in any production system. The goal of a pull-based system is to limit inventory and work in process (WIP) items while ensuring that the requisite materials and information are available for a smooth flow of work. In other words, a pull-based system allows for Just-in-time delivery.

Pull-based systems are always created from the needs of the end customers. By following the value stream and working backwards through the production system, you can ensure that the products/ services produced will be able to satisfy the needs of customers.

It is very important that businesses manage stock and WIP, they should only stock what has been ordered for, and establish channels through which stock can be quickly brought in, incase need arises. The cost of stocking and also keeping stock can be overwhelming on the business, and at this time when businesses are trying to recover from the shocks of the Covid-19 pandemic it is very important that such a waste is managed accordingly.

Service companies should also concentrate on works that have been ordered for, and give more time to work where the customers have made commitments in terms of payments, this will enable these organizations to minimize the risk of doing work for clients who do not pay for the work done. This can be done by developing working contracts and also including payment terms which implore clients to make certain percentage of the payment before the work can be started.

PURSUE PERFECTION

This last stage establishes a very important aspect of the business, which is for the business to thrive it must ensure that it pursues quality in everything it does, and it should also strive for continuous improvement. Continuous improvement entails continuous learning, continuous innovation and development, and it calls upon all the members of the company to be part of the continuous improvement program.

It is very important that companies keep pursuing perfection and continuous improvement so that they keep looking for cost effective ways of doing business.

THE ROCKET MODEL IN BUSINESS DEVELOPMENT

The rocket model is a business growth and product development model that focuses on how businesses
can transcend through the various stages of the economic environment. The model imitates the
different stages that a rocket goes through as it travels through the atmosphere to reach space and then
orbit.

The earthly environment has similar dynamics to the business environment, it can be smooth at some
level, and rigid at other times, it requires various techniques to sail through this environment without
facing a catastrophic end, in this article we go through the various stages that a business rocket goes
through as it travels through the atmospheric/ economic environment to reach orbit (success).
First we need to look at the lay out of the space craft, on the bottom is the booster rocket powered by 9
rockets in the case of the falcon 9, the second engine, and the capsule in which astronauts sit and cargo
to space is packed, all these are manned by a control team in the control tower at the launch station.

In this analogy the three components that make up the space craft are explained as below;
> Booster rocket: Includes the delighters; these are traits that delight the user of the product or
the services, but they do not necessarily satisfy the customers’ needs.
> Second Engine: These are satisfiers, quality that makes the product usable, like safety, reliability,
etc., but also do not address the need of the customer.
> The Capsule: This is the real product/ services and the actual need it was designed to fulfil.
> Control Team: The business development team that is brought together for product/ service/
business development.
We shall now go through the rocket launch model step by step;

1.PREPARATION FOR LAUNCH:
The greatest work takes place at this stage, for a rocket to be
given a green/ to launch, thorough inspection is done to make sure that there are no errors at
all during launch and after launch. Building a space craft in itself is very hard, and extensive tests
are carried out to make sure that the space craft is tested through all dimensions it will go
through as it ascends up into space, this is because post launch repairs and fixing damages is
very difficult especially when the craft is already in space, it costs a lot of money in billions of
dollars to just send another space craft to repair damage on a space craft that is already inspace, not to mention the cost of having a rocket explode post take off, as it can havecatastrophic damages to life as well. Businesses need to adopt the thoroughness that is employed in the preparation for launch, forany product/ service before being launched it should be thoroughly tested, checked, double andtriple checked before it is released to the market, because it would cost a lot more money to recall products to correct any errors, mal functions, and in some cases the damage is too much that the company brand is cast in daught into the eyes of the consumers. Sometimes recalls/ redoes are soo catastrophic that they can lead to companies to close and lose billions of money as well, for example Takata a company that manufactures air bags for virtually every automaker, faced a recall cost of about $24 billion in 2008 and had to recall more than 37 million vehicles, this was due to faulty air bag inflators made which would explode and eject a shrapnel like material that has been linked to at least 20 deaths (Burrows,2018), the question raised was, why weren’t thorough tests done to make sure that such errors could be detected and corrected before the air bags were put into the market?

    2.THE LAUNCH STAGE:
    For all involved in the space rocket business, the epitome of their success
    is when they hear the air space controller announce that “We are now ready for Launch” all the
    hard work done comes to this stage. We are ready for launch, at the end of the launch is a
    control team, that will monitor all the time the different dynamics as the space craft travels to
    space. For a business, it is an exciting time when launching a new product/ service/ making a
    business cultural or management change, all the hard work put in to design the product/
    services comes to this moment of the launch. However, businesses need to construct control
    teams, to monitor the performance of the products and services that have been launched.
    Before any product and services is launched, the control team needs to have all unanimously
    agreed that the product / service is ready for launch.
    During the launch the rocket uses a lot of power and energy, the falcon 9 starts with all 9
    engines being ignited and fired at the launch to enable it lift up. In business for all the products
    launches the whole organization must be involved, the business needs to use all its available
    resources including people to ensure that a safe and productive launch is successfully done,
    everyone in the business must know every detail about the product or services, before it can be
    launched to the market. Usually management teams underscore the importance of involving lower staff in products/ services launching, they trivialize the importance of the lower level staff in marketing and
    promoting the products being launched, it is very important that the whole body of staff are in
    sync about the products and services that are being launched.

    3.MAX-Q:
    After launch the rocket starts to experience different dynamics as it ascends into space,
    this is because it travels through various atmospheres as it ascends up, and as it goes up, the air
    density increases as the rocket also attains speed, however due to change in the pressure being
    exerted on the rocket as it goes up into space, at some point the rocket will get to a point where
    the atmospheric pressure is at its peak, and if the rocket is to continue increasing its velocity,
    the dynamic pressure can cause it to explode. Max-Q is dreaded by the space control team, but
    to sail through it, they have to throttle down on the engines power.
    After the launch, the product if very successful, it will also go through Max-Q a point where the
    resistance the product/ service will get from competitors and imitators is soo much, every
    company will be yarning to make a similar or even better product, the biggest mistake the
    company can make is to increase intensity and try to fight off the competition, instead they
    need to throttle down observe the product and see how best to improve it.
    During the early 2000 Nokia was the biggest mobile phone company, it had great products
    especially the Nokia 3210 which was warmly received in the global market, Nokia increased its
    mass production of phones, forgot to take a step back and observe what the other emerging
    phone tech companies were doing, they failed to improve on what they had built and instead
    they were hit with Max-Q, companies like Samsung, Apple, etc have now bypassed Nokia in the
    phone business, and even at their peak, these companies have remained very innovative and
    they have consistently sought ways of how to make the users’ experience much more better,
    and this is what has kept them way above their competitors.

    4.MECO (Main Engines Cut Off):
    As the rocket continues up into space, as it nears to go into orbit,
    it will have to let go off the booster rocket, and this stage is called MECO; at this stage three
    things happen simultaneously, first the 9 engines that are fired at launch on the booster rocket
    are cut off, secondly the booster rocket separates from the capsule and it returns to earth, and
    thirdly the second engine attached to the capsule is ignited and it is this engine that will send it
    into orbit. The booster will separate from the capsule at this level and for the case of the Falcon
    the control team will attempt to land it safely for re-use on other missions.

      At this stage in business, it is very important that the control team looks to improve the
      different product traits that delight the customer, they will need to further improve the product
      and there are some things that need to be removed from the product and let go, and new traits
      introduced, new delighters that will carry the products further into the market and in the eyes
      of the consumers.
      It used to be very cool to hold a small phone but not anymore; size , colour, shape, etc. these
      are all delighters, from the mid-2000s most of the manufacturers of mobile phones
      concentrated on the manufacture of very small phones, pocket size phones, but this trend has
      since been abandoned by most phone manufacturers, now bigger sized phones with bigger
      screen sizes are more wanted by customers, phone manufacturers like Samsung and Apple have
      now gone ahead to venture into the production of IPads, and Tablets that have both phone and
      computer capabilities, and this is what it means to let go of some delighters and introduce new
      ones.
      For products to continue on the upward curve of growth, they need to evolve, they need to
      excite their users, and companies need to understand that they cannot maintain the same
      products for eternity, the production team has to keep innovating and changing, investment in
      research is paramount, but they also need to know they have to let go of certain traits and
      introduce new ones if the products are to continue being successful in the market, this is what
      has kept big companies up in their different markets they dominate.

      5.SECO (Second Engine Cut Off):
      As the rocket enters orbit, it has to let go off the second engine as well, and the capsule will continue into orbit.

      It is very common in product development, that when a product is being developed they try to incorporate a lot of attributes to it, so as to give it an edge over the others, but as the product becomes more successful in the market and becomes more appreciated by the end user, they will want to see something that differentiates this product from the other similar products, therefore it becomes very important that the development team drop some attributes and concentrate on that one or two that will give them an edge over the competition.

      The product development team needs to pay close attention to the qualities that make the products usable, the features that make the product be chosen by the customers despite the presence of many substitute products, features like reliability, safety, re-usability, ease of use, etc. These are very important attributes that need to be changed time to time, at different stages of a product life cycle, customers may require one attribute over the other, and because of the cost constraints, the management team needs to know what attribute is more needed than the other and concentrate on that, it is very common for many companies to try to fulfill all the attributes that make the product usable, but in most cases they fail to nail down even one, that is very visible and appreciated by the end user.

      Apple has greatly been able to do this, they have prioritized user data safety and they have put features on the IPhone, that make sure that the user’s data integrity and safety is secured. Over the years they have tried to incorporate different aspects and attributes, but now many people buy the iPhone on the basis of safety of information, they believe that their data on the phone is soo secure, and the ability to track the iPhone using the serial number when stolen is another key feature that shows how much Apple has invested in making the iPhone the safest phone to use. The product development team need to ask themselves, what attribute should we prioritize on now, and what should we drop?. For the product to continue to grow and be successful in the market environment it should have a differentiating feature that keeps it head and shoulders above the other products.

      6.Orbit:
      In the old space program they used to fly shuttles to space and these would orbit earth or
      deliver items to the International Space Station (ISS), but of late space X has developed the
      capsule which is used to orbit, upon successful entry into space.
      There are different facts that happen while in orbit, for example; for a capsule to remain in orbit
      successfully, it must maintain a certain speed and altitude above the surface of the earth, and
      secondly a space vessel orbits earth every 90 minutes at a speed of 17,500 miles per hour.
      Once products have gained significant success in the market, it does not mean the businesses
      that launched them can now relax, because success and failure can both kill (pastor Joshua
      Selman), over relaying too much on the success can lead to complacency and as we know
      competitors are always waiting for one mistake to take you down, therefore companies must
      maintain speed in innovation and product improvement even after it has been successful. They
      must make sure that innovation drives the products far above other products, there should
      always be a distance they maintain between their products and the competitors’ products in
      terms of differentiation.
      Space is a vacuum with no air and under normal circumstances we would not expect any danger,
      however this is not true, in space there are travelling debris, fragments from old satellites, etc
      and these can hit the capsule and it can be destroyed immediately, this is what success does,
      one mistake and all the success stories can be buried forever.

        We have many companies that have faced the tragedy of failure after being soo successful,
        companies like, Nokia, Kodak a company that dominated the photography industry during most
        of the 20 th Century, they failed to keep innovating and eventually filed for bankruptcy in 2012,
        Xerox continued to use the same photocopying technology until new companies like
        HP(Hewlett-Packard) came with superior technology and threw it out of the market, other
        companies that have gone down the same road of too much success then failure due to
        complacency and failure to innovate include; Hitachi, Myspace, Toshiba, Motorola, Netscape,
        Compaq, and many more others.
        In our next segment of business growth, we shall be discussing how to assemble a competent
        and effective control team for product development.