The impacts of inventory in transfer pricing and net income: Differences between traditional accounting and 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.
Section snippets
Literature review
This section aims to provide a basic understanding of the concepts used in our research. We will first present the systematic literature review (SLR) conducted for our study, which is followed by the background literature on throughput accounting and on the relevant transfer pricing problems.
The systematic literature review search was conducted in the Scopus and Web of Science (WOS) databases using the defined keywords and search terms shown in Appendix A and delimited by publications from the
Methodology
Bertrand and Fransoo (2002) mention two types of quantitative models: axiomatic and empirical. Empirical models focus on fitting the model according to observations and reality, while axiomatic models aim to achieve solutions within a specific model and ascertain that the solutions obtained give insights into the problem structure. Additionally, they also differentiate normative and descriptive research. Normative research is concerned with developing policies, strategies and actions to achieve
Model presentation
This section covers the model construction, explaining its logic and detailing the sectors within it, followed by an explanation of the process used to validate it.
Results and discussion
To make a full analytical comparison of the company, we added one more sector to the model. Basically, we used two variables to report the aggregate net income after tax in Unit A and Unit B. Fig. 5 demonstrates these sectors.
We first made a simulation to see the results of the net income after tax with the inventory costs and compared the GAAP accounting method and that of throughput accounting. To do so, we used the Stella sensitivity analysis functionality. We made a scatter chart comparing
Concluding remarks
In this research, we aimed to fill a gap in management accounting and control regarding international TP settings (Cools & Slagmulder, 2009). We propose the utilisation of throughput accounting and demonstrate the importance of inventories in those scenarios. Our main contribution lies in the presentation of TA, from a management control perspective, as a valuable alternative to GAAP – addressing, at the same time, some of the operational concerns from traditional accounting methods.
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