The impacts of inventory in transfer pricing and net income: Differences between traditional accounting and throughput accounting

Abstract

This research proposes the Theory of Constraints (TOC) throughput accounting (TA) as an alternative management control mechanism in an international transfer pricing setting. We compare TA with the traditional accounting method and demonstrate that the traditional method underestimate factors as demand variation and inventories, which affects decisions, such as moving production to an offshore plant. A detailed system dynamics model is built to simulate the production process in an offshore supply chain to compare the methods. The study aims to fill a gap in the management accounting studies and contribute to the understanding of international transfer pricing and their management controls, exploring more than just the tax savings, which are usually considered isolated from operational factors for supply chain (SC) offshoring decisions. Furthermore, we conduct a brief literature review, present the model and discuss the results. It has been observed that inventory levels are an important part of accounting, offshored supply chains, and transfer pricing. Traditional cost and accounting methods favour higher inventory levels, and they can overestimate net income results up to 70% – especially in higher demand variation scenarios – when compared to the throughput accounting.

Introduction

Multinational supply chains make use of offshoring for cost-reducing reasons like tax avoidance (Joseph et al., 2017) and cutting operational costs (Drtina & Correa, 2011). Consequently, the transfer of goods within these supply chains has become a topic of interest. Accordingly, multinational enterprises (MNEs) utilize the transfer price to sell goods from one Supply Chain Unit to another in the same company. Thus, transfer prices can be defined as the pricing of intercompany transactions that occurs within its own subsidiaries (Feinschreiber, 2004).

Although widely discussed, transfer pricing has become a concern for multinational companies. In a report from Ernst & Young (2016), p. 75% of the companies studied claimed that their major priority about transfer pricing was related to tax risk management, while 72% assumed that transfer pricing has been a core focus of controversy within organisations. This controversy might be related to the fact that companies still consider isolated benefits, commonly only tax avoidance or production and operational costs (Joseph et al., 2017), demonstrating a gap in accounting and supply chain management perspectives as stated by Ramos (2004). This gap is concerning, since building a strong foundation of sound accounting techniques is key for supply chain collaboration (Vann, 2016). To Borkowski (2002) transfer prices present challenges related to tax compliance, supply chain management, and the location of manufacturing facilities, i.e. offshoring. More specifically, there is still a gap between international tax objectives and the operational decisions of management control in MNEs, as noted in studies such as the ones by Baldenius et al. (2004), Hyde and Choe (2005), and Narayanan and Smith (2000).

Tax optimisation motives and the usage of generally accepted accounting principles (GAAP) – absorption or full costing methods – are often considered unfavourable for the optimisation of operational aspects regarding transfer prices such as sourcing, pricing, and inventory decisions. In those scenarios, the utilisation of variable costing methods can provide better guidance to managers and are seen as a valid option for management control (Eccles & White, 1988; Horngren et al., 2004). Management accounting and control studies, however, have given little attention to transfer pricing in international settings (Cools & Slagmulder, 2009). From this perspective, concerned with the negative impact of inventory reduction demonstrated in GAAP, the Theory of Constraints (TOC) proposes the throughput accounting (TA) as an alternative (Budd, 2010; Hilmola & Li, 2016). In TA, throughput is defined as revenue minus all the variable costs – i.e. manufacturing, general, selling and administrative (Brignall, 1997; Budd, 2010). TA can be similar to variable costing, following the same concepts of it, but differing in that it can recognise labour as a fixed cost (Boyd & Cox, 2002; Budd, 2010). Since transfer pricing occurs in international transactions where longer delivery times are expected, and, consequently, higher inventory levels occur, a comparative study between the GAAP and throughput accounting concerning the impacts of transfer pricing in offshore supply chains is important. However, as pointed out by Budd (2013), there is a lack of TOC literature in accounting and finance. So far, the TOC literature has considered only local or domestic transfer prices (Ronen & Pass, 2008). An analysis considering the international transfer price setting, as proposed in this paper, has not been identified in the TOC literature as well.

In a broader sense, with an accounting perspective in a supply chain context, the relationship between these two topics is also explored. More specifically, this work aims to fill the gap in management accounting and control studies proposing throughout accounting as an alternative and demonstrating the importance of inventory considerations in an international transfer pricing (TP) setting. We demonstrate that by conducting a preliminary comparative study of the GAAP and throughput accounting, which could lead to better understanding of the impacts of offshoring operations and international transfer pricing on supply chains, based on the TOC perspective. Therefore, we analyse the importance of inventory levels in a transfer pricing setting and the impacts on the Net Income After Tax using and comparing GAAP and throughput accounting. To do so, a basic transfer pricing example was created, and a sensitivity analysis was conducted through simulation in a system dynamics model. We demonstrate with our analysis that inventories affect the optimal transfer price, that the traditional cost and accounting methods favour higher inventory levels and that it can overestimate net income results – especially in higher demand variation scenarios – when compared to the throughput accounting.

The main contribution of the paper is to demonstrate that TA can be used as an alternative to GAAP accounting for management accounting and control, addressing serious disadvantages and concerns presented in absorption costing (GAAP) methods. Thus, we show that it can support supply chain decision-making regarding the offshoring of operations and that inventory levels play an important role in such settings. As, in those scenarios, the suggested usual performance metric is profit and/or return on investment of company divisions (Smolarski et al., 2019), the traditional accounting method can be misleading to managers, as they tend to overestimate profits based on inventory levels. The throughput accounting tries, in this case, to diminish this problem by being more restrictive regarding the gains derived from inventories, as it accounts only variable costs in its value.

The remainder of this paper is structured as follows: the next section provides a brief literature review on throughput accounting and transfer pricing. Section 3 covers the research methodology. Section 4 presents the model. Section 5 presents the results and the discussion, and Section 6 concludes the study.