Transfer Pricing Methods and Models

person calculating financial info
Transfer pricing shifts funds internally. John Lamb/Photodisc/Getty Images

Transfer pricing is a key element in management reporting systems that decompose aggregate corporate profits into more finely grained profitability analyses by, for example:

  • Organization (such as division, business unit or department)
  • Geographic Region
  • Product
  • Client Segment
  • Individual Client

In short, transfer pricing involves rearranging the reporting structure of revenues and expenses, from the structure in the legal books of the firm to a new structure that better shows management the economic realities of its activities.

Additionally, transfer pricing may be used in the filing of corporate income tax returns. If the company operates in multiple jurisdictions or countries, its total revenues or income may have to be divided among these geographic regions for tax purposes, via transfer pricing mechanisms. These may or may not be the same mechanisms used for management reporting and internal analysis.

Transfer Pricing Case Study:

In the mid 1980s, Merrill Lynch was in the vanguard of Wall Street firms that sought to develop these lower level analyses of profit. Merrill Lynch's president and chief operating officer (COO) at the time, Daniel P. Tully, had expressed frustration with inconsistent profitability reporting at the divisional, business unit and departmental levels, making it difficult to conduct strategic business reviews with confidence.

Tully's major complaint was that the profit figures reported out by the individual organizations were not driven by a consistent, centralized methodology that footed to total Merrill Lynch and Co.

profits, as they appeared in the firm's annual report, 10-K and 10-Q filings. Instead, all these organizational profit and loss statements invariably would add to a multiple of the firm’s aggregate profits, a situation that Tully (who several years later would succeed the retiring William A. Schreyer as Merrill Lynch Chairman and CEO) found completely illogical and indefensible.

By the late 1990s, the widely-respected strategy consulting firm McKinsey & Co. would cite Merrill Lynch as having the most sophisticated profitability analysis systems in the financial services industry, and among the very best across all industries. A critical element in this evolution of management reporting at Merrill Lynch was the firm's continuing refinement of the transfer pricing methodologies that were at the heart of its profitability analysis systems.

The Transfer Pricing Concept: ​

In large companies, multiple organizations often are involved in the manufacture and delivery of products and services to clients or customers. To analyze profits by organization, there thus needs to be a mechanism to attribute portions of the revenue streams earned by a given product to the various organizations involved in its manufacture and distribution. In similar fashion, the expenses incurred by various cost centers, such as information technology and back office operations departments, also must be attributed to the various organizations being credited with the revenues from the products with which these expenses are associated.

Revenue Assignment Examples: ​

Within a securities firm, a classic transfer pricing problem involves a scenario similar to this.

The revenues from a security transaction (for example, the purchase or sale of a stock or bond) are recorded on the legal books of a trading desk. This is in accordance with standard reporting conventions for audited financial statements, as well as for regulatory reporting requirements. However, the client for whom the transaction was made actually "belongs" to a different business unit, the profitability of which is measured separately in the firm’s management reporting system.

To be more specific, the typical transfer pricing scenario would be one in which a financial advisor places a trade on behalf of a retail client, and the trade is then executed on a principal basis (that is, out of the firm's own securities inventory, rather than on a securities exchange or with another firm that makes a market in that security) by a securities trader employed elsewhere in the firm.

In accordance with standard accounting practices within the securities industry, the revenue associated with that trade would be booked to the trading desk. However, the financial advisor and the retail brokerage network clearly added value in this transaction, and thus deserve to be attributed some proportion of the total revenue realized by the firm on the trade.

The general rule of thumb in this situation is that, for management reporting purposes, the revenue attributed to the trading desk should be amount that it would have realized if the transaction were with a large institutional client. The additional premium or markup that was charged to the retail client would represent the value added by the retail brokerage system, and this amount would be assigned to it via transfer pricing.

Transfer pricing methodologies, in this scenario, depend on largely on the ability to decompose the total revenues earned on the trade into the base price that would have been paid by a large institutional client and the additional revenue that the small retail would actually contributed, as a result of getting less favorable pricing. Ideally, each trade record would include this decomposition, but not all firms and trading systems are set up in such as fashion to facilitate transfer pricing analyses. In these cases, other, less precise methods of estimating transfer pricing amounts must be developed, such as statistical sampling of trading activity.

Expense Transfer Examples: 

Continuing with the Merrill Lynch example, the firm developed a very complex system of expense transfers that it called "the economic map." In general, this involved a detailed analysis of operations departments, determining what profit centers and products they supported. Then, appropriate cost drivers were identified and measured. For example, it might be determined that a given operations department supported several securities products and that the appropriate cost driver was the number of securities transactions. Thus, the total costs of that department would be mapped to profit centers based on the percentage of total transactions that each sent through the operations department.

Within the retail securities brokerage division of the firm, originally called the Consumer Markets Division and later the Private Client Division, a further analysis of profitability by product was conducted. This also utilized a complex series of cost drivers depending on the type of work performed by a given operations area. For example, a department that provided record keeping for client accounts might have its costs assigned to the various types of account (each of which represented a different product) based on the relative numbers of new account openings or base of existing accounts. 

Financial advisor compensation, meanwhile, would be attributed across securities products based on the production credits generated by each, for example. For the various types of client accounts, the portion of financial ​advisor compensation paid out for asset gathering activity would be divided among them based on the breakout of that activity across the account types. These are just some examples among many.