Originally published: February 2024
In the last season of Mad Men, Don Draper finally ends up at a big advertising firm. He joins a meeting to discuss a Coca Cola ad pitch with 30 or so other advertising gurus. Draper looks around wondering how his work could have any discernible impact. He gets up and leaves. The meeting carries on as if nothing happened.
Transfer pricing (TP) is a bit like trying to measure the individual contribution of each person in that meeting. Presumably, having 30 people there rather than allocating the task to the best 10, 5 or 1 results in a better result (ie profit) due to synergies. But pinpointing individual contributions is hard, just like assessing profit contribution of individual entities in an MNE group. You can revert to proxies like cost or salary, but we all know some people are underpaid, some overpaid and some have a negative contribution. If you could figure out who’s who, writing TP reports is probably one of the less lucrative ways to monetize that skill.
This 2018 paper by Aitor Navarro (https://lnkd.in/eMK9hZ9N) analyses how to allocate profits from synergy benefits within an MNE group. Those benefits include (1) lower transaction costs (less contract negotiation, knowledge gap, trust gap), (2) economies of scale, (3) pricing advantage of vertical integration and (4) coordination benefits. Allocating this uplift in profitability cannot be done on a pure arm’s length basis, as these benefits don’t occur in arm’s length situations. For instance, the seller of a tested transaction might have accepted a price of 80, but the buyer might have accepted 120. So where should the price end up?
Navarro argues applying a limited “arm’s length” approach, where parties are assumed to use their relative bargaining power to claim synergy gains. In his view, a pure “arm’s length standard” would risk having unallocated synergies profits, defaulting to where the contracts says the profits end up. Allocating the profits based on bargaining power seems more sensible and in line with TP principles. After all, if two unrelated parties can realise a windfall, they would also allocate the gain through negotiations.
But there are practical challenges. It is often difficult to identify the synergies benefit and there is usually no shortage of leaders claiming their individual contribution was decisive in commercial success. Even where identified, it can be hard to determine relative bargaining power.
Draper’s boss was frustrated by his disappearance and considered the money invested in attracting him a sunk cost. Draper spent his time off the radar in a hippy resort. While in meditation there, he comes up with a groundbreaking Coca Cola ad in the final moments of the series. So, in hindsight, his contribution to profits easily surpassed the other 30 people in the room. And it was not even close.
Obvious disclaimers: this is not advice. These views are my own and do not necessarily represent my employer.
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