Reading-Pricing for Global Markets

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S. Tamer CavusgilMarkets

Pricing is complex and generally subjective in do-mestic business. It is even more difficult in interna-tional business, with multiple currencies, tradebarriers, additional cost considerations, and longerdistribution channels. Based on a review of corpo-rate best practices, this article proposes a set of de-cision rules and processes for international pricesetting. Specific topics for discussion include: keyconsiderations in international pricing; the locationof pricing responsibility in the multinational corpo-ration; approaches to price setting; and transferpricing practices.


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S. Tamer C avusgil is John WilliamByington Endowed Chair in GlobalMarketing and executive director ofthe Center for International BusinessEducation and Research (CIBER) atthe Eli Broad Graduate School ofManagement at M ichigan State Uni-versity.

The globalization of marke tinghas put tremendous pressure onMNC pricing systems. Over the pastfew decades, as companies movedfrom purely domestic operations toexporting and then to overseas manu-facturing and marketing,, they had totransform their pricing structures.Those structures., originally set up tofunction in A single-market setting,had to be adapted to the muchgreater heterogeneity of the interna-tional environment.

Today, perhaps for the first time,the operating environment thatMNCs face is replete with complexi-ties, including competition, an in-creasing number of global players,rapid technological change, and high-speed communication among mar-kets.Executives of internationally ori-ented firms must now grapple withmany questions to which there areno simple or precise answers; for ex-ample;

What is the best approach for set-ting prices w orldwide? Which variables should be consid-ered in arriving at prices for foreigncustomers? What level of importance should beattached to each variable? Where in the global companyshould pricing decisions be made? Should prices vary across markets?By customer types? Over time? Should price play an active or pas-sive role in a compa ny's internationalcompetitive strategy? and What factors should MNCs con-sider in setting transfer prices?

Most executives are quick to rec-ognize that pricing decisions cannotbe nnade in isolation, since pricing in-teracts with and affects all other mar-keting policy variables. Among otherthings, prices do the following: Influence customers' perception ofvalue; Determine the level of motivationthat can be expected of intermediar-ies; Have an impact on promotionalspending and strategy; and Compensate for weaknesses inother elements of the marketing mix.

The purpose of this article is to re-view corporate practices in interna-tional price setting. Pricedetermination is far from being scien-tific in the international environment.Pricing becomes, in part, trial and er-ror and partly hard calculations bymanagement. Yet, managers have de-' veloped a set of decision rules andsuccessful approaches to settingprices for international customersand subsidiaries. The discussion herecrystallizes this thinking and suggestsa more systematic approach .Factors That Affect Global PricingGlobal managers readily acknow-ledge the critical role of prices inoverseas marketing success. After all,prices do have a measurable impacton sales and directly affect profitabil-ity. They often invite competitive re-action and, indeed, can be drivendown by determined competitors.Conversely, they can escalate to un-reasonable levels because of tariffs,taxes, necessary increases in markupsto cover rising costs and so on. Theycan complicate a firm's marketing

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strategy in unforeseen ways whenprice variations among different mar-kets lead to gray-market imports (Ca-vusgil and Sikora 1988). Finally,prices are one of rhe most flexible ele-ments of the marketing mix, becausethey can usually be cbanged rela-tively quickly.

Consequently, MNCs take greattime and care in establishing pricingpolicies and setting prices for interna-tional customers. In addition to thebasic factors of production cost, de-mand and competition that must beconsidered, pricing decisions for theglobal market must take into accountvariables such as exchange rate fluc-tuations and duties as well as exter-nal costs, e.g. docume ntation, freightand insurance.

Within the large constellation offactors that influence pricing for in-ternational markets, the five dis-cussed below stand out as mostimportant.1 Nature of Product or IndustryA specialized product, or one with atechnological edge, gives a com panyprice flexibility. In many marketsthere is no local production of theitem, government-imposed importbarriers are minimal, and importingfirms all face similar price escalationfactors. Under such circumstances,producers are able to remain competi-tive with little adjustment in pricestrategy.

A relatively low level of price com-petition usually leads to administeredprices and a static role for pricing inthe marketing mix. In such instancesa "skimming" price strategy is oftenused. Eventually, however, as pricecompetition develops and technologi-cal advantages shrink, specializedand highly technical firms must make

more and more market-based excep-tions to their previously uniform pric-ing strategies.Pricing strategies are also influ-enced by industry-specific factors,such as fluctuations in the price and

availability of raw materials. In orderto reduce uncertainty, a growing prac-tice of companies is to negotiatefixed-price agreements with suppliersbefore making their own bids for ma-jor contracts.Another problem for corporationsin some industries is predatory pric-ing by particularly aggressive com-petitors. Recently, that strategy hasbeen pursued mainly by market-share-hungry new players, most nota-

bly those from just recentlyindustrialized countries (NICs) inAsia.2 Location of Production FacilityDespite the proliferation of foreign-owned manufacturing facilitiesaround the world, many companies'only participation in the global mar-ket is by exporting products theymake in their home countries. Theusual reason is that the volume oftheir sales abroad is simply not largeenough to justify foreign soutcingand manufacturing.

When production is kept at home,a company is tied to conditions pre-vailing in that market, a circum-stance that reduces its pricingflexibility in its export markets. Eco-nomic and political developments athomeand even natural disasterscan force export prices up at a timewhen local producers in the overseasmarket or exporters from third coun-tries are not similarly affected andcan keep prices low.

One exatnple might be a trade em-bargo observed by only a few govern-

ments. Because of the boycott, thesupply of certain needed raw materi-als would be reduced, driving up thecost of making some produ cts. Com-petitive products made in nonboycot-ting countries would obviously enjoya clear price advantage in export mar-kets.

In contrast, companies that manu-facture abroad often enjoy greaterpricing flexibility both in the coun-tries in which they are located and inexport markets. In addition to beingbetter able to calibrate production tolocal demand and competitive condi-tions, those MNCs find it easier to re-spond to foreign exchangefluctuations. Mazda paid a heftyprice for not building production ca-pacity outside of Japan. As the Japa-nese yen appreciated significantly inthe mid-90s against the U.S. dollarand most other currencies, Mazda'sexports of vehicles from Japan be-came prohibitively expensive.Mazda's only assembly plant outsideof Japan, the Elat Rock, Michigan, fa-cility never became a big factor. Afterregistering big losses for severalyears, M azda's chief creditor, Sumi-tomo Bank, finally asked Eord totake a controlling interest in Mazdaand appointed a Eord executive as itsnew president (Reitman, 1996).

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3 Distribution SystemThe channels of distribution a com-pany uses dictate much in interna-tional pricing, particularly exportpricing. When a company is able todistribute its products through itsown overseas subsidiaries, it hasgreater control over final prices, in-cluding the ability to adjust pricesrapidly, as well as firsthand knowl-edge of market conditions.

An exporter working with inde-pendent distributors, however, usu-ally finds that it can control only thelanded price {the exporter's price tothe distributor). As one might expect,many exporters are concerned abo utthe difficulty of maintaining price lev-els. Some firms report that distribu-tors mark up prices substantiallyupto 200 percent in some countries. Useof manufacturers' representativesgives a company greater price con-trol, but this method is used less fre-quently by U.S. companies, whichusually require a "full-service" inter-mediary in the export market.

Direct selling to end users is neces-sary in many industries, especiallythose involving large systems or tech-nical equipment. In the case of salesto government agencies, a protractedbidding process and negotiations pre-clude the use of list or other standardprices. Eirms often attemp t to estab-lish more direct channels of distribu-tion for reaching their customers inoverseas markets. Indeed, that issometimes a motivation for estab-lishing a company-owned subsidiary.By reducing the number of intermedi-aries between the manufacturer andthe customer, the adverse effects ofsuccessive markups can be avoided.

4 Location and Environment of theForeign MarketPricing is affected by factors not al-ways immediately perceived as pricerelated. Eor instance, climatic condi-tions in foreign markets may necessi-tate costly product or distributionmodifications, and prices must be ad-justed to cover those extra or specialexpenses. A maker of soft drinkequipment must treat its machines in-tended for tropical markets to pre-vent rust corrosion, while anagribusiness must take into accountclimate, soil conditions, and the coun-

try's infrastructure before makingany bid.5 Foreign Cu rrency DifferentialsEconomic factors, such as inflation,exchange rate fluctuations and pricecontrols, may hinder market entryand effectiveness. These factors, espe-cially the value of the U.S. dollar inforeign markets, are a major concernto most firms. The dollar's unusualstrength in the first half of the 1980s,in fact, led a number of companies tointroduce compensating adjustmentsas part of their pricing strategies. Incontrast, during the first half of the

International Pricing Strategies UnderVarying Currency Con ditionsWhen the Domestic Currency is WeakStress price benefits.

Expand product line and add more costly fea-tures.

Shift sourcing m anufacturing to domesticmarket.

Exploit export opportunities in all markets.

Use a full-costing approach, but em ploy mar-ginal-cost pricing to penetrate new or com-petitive markets.

Speed repatriation of foreign-earned incomeand collections.

Minimize expenditures in local or host-coun-try currency.

Buy needed services (advertising, insurance,transportation, etc.) in domestic market.

Bill foreign customers in their own currency.

Wher) the Domestic Currency is StrongEngage in nonprice com petition by improving

quality, delivery and after-sale service.Improve productivity and engage in vigorous

cost redua ion.Shift sourcing and manufacturing overseas.

Give priority to exports to countries w ithrelatively s trong currencies.

Trim profit margins and use marginal-costpricing.

Keep the foreign-earned income in hostcountry: slow dow n collections.

Maximize expenditures in local or host-country currency.

Buy needed services abroad and pay for themin local currencies.

Bill foreign customers in the domesticcurrency.

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1990s, U.S. exporters enjoyed amuch weaker currency, boostingtheir sales in international markets.

Since currency fluctuations are cy-clical, exporting com panies tha t findthemselves blessed with a price ad-vantage when their currency is under-valued must carry an extra burdenwhen their currency is overvalued.Companies committed to serving in-ternational markets must be creative,pursuing different pricing strategiesduring different periods. Appropriatestrategies practiced by a broad cross-section of MNCs are presented in Ex-hibit 1.The Locus of Pricing Decisions inMNCsCentralized PricingInternational pricmg decisions arecentralized in most global compa-nies. There are several reasons forthat;

1 Increasing globalization of mar-kets requires greater uniformity ofprices across markets. The existenceof differing prices from country tocountry often leads to gray-marketimports, i.e. the sourcing of a prod-uct from low-price countries by un-authorized intermediaries for sale inhigh-price c ountries. This results inthe creation of a distribution channelparallel to authorized channels butnot under the control of the manufac-turer in any way.

2 Global comp anies encounterthe same competitors in many mar-kets, requiring globally coordinatedcompetitive strategies. A fragmentedstrategy often leads to suboptimal re-sults.

3 At some compan ies, pricing isclosely related to production-volumeplanning. Since volume planning isusually done at the corporate level, itrequires centrally directed prices.4 Typically, the pare nt com panywants to forecast its annual revenuesworldwide. Therefore, it must beable to estimate the sales of all its op-erations, including its overseas sub-sidiaries. This often dictates settingprices centrally or, at least, imposingsome guidelines for the prices to beset by subsidiaries.5 Many corporations seek tightcontrol over pricing of their "global''

brands, that is, those aimed at a ho-mogeneous market segment in manycountries and positioned similarlyfrom one m arket to another. To cre-ate a uniform image across nationalboundaries, not only the product,but the price, must be consistent. Theprice is normally set by corp orateheadq uarters relative to the prices ofcompeting local products in eachmarket. The policy might state, forexample, that the brand must alwaysbe premium priced relative to localproducts and that "p remium " is de-fined as, say, 20% above the price ofthe most expensive locally produceditem. Such a policy limits local auton-omy in setting prices. An exam ple ofa global brand priced in this manneris Grand Metropolitan's Smirnoffvodka. Gillette is another companythat seeks "a global brand image forits products.

Also important to a company'spricing policies and practices is theproximity of its overseas markets toone another. When markets are closegeographically, a country subsidiarycannot set prices for its own market

In isolation. No subsidiary can markup the price to the point at which cus-tomers will seek to import the prod-uct rather than buy locally.Centralized pricing management bythe parent company or a regional of-fice is often the only way to preventsubsidiaries from undermining oneanother's pricing programs.Decentraiized PricingAlthough global companies generallymaintain centralized contrt)! over lo-cal prices, tbey do allow subsidiariesto alter prices when vt'arranted by lo-cal conditions. In some situations,subsidiaries may, in fact, receive com-plete pricing autonomy because ofcompetitive considerations.

Headquarters executives cite thefollowing reasons for giving subsidi-aries or distributors leeway to set lo-cal prices: Tim ing. There tnay be a need fora quick response to price changesmade by competitors. Relative mark et share. If thebrand is one of many in a local mar-ket, the subsidiary will be forced tofollow the prices set by the marketleaders. Conversely, market leader-ship allows greater pricing freedom. End-user characteristics. If the lo-cal market is relatively poor, withmost consumers at lower income lev-els, the local subsidiary may have todeviate from centrally determinedpricing guidelines. Specific local cost factors. Value-added taxes and the cost of adaptinga product to a particular market maydemand greater price flexibility insome countries.



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Tran sportation costs. These varywidely from country to country ow-ing to the nature of the distributioninfrastructure, the extent of imioniza-tion in the transport industries andthe stipulations in local distributionlaws.Economic and financial condi-tions . Interest rates and inflationoften cause local divisions to swayfrom corporate pricing guidelines. Lo-cal prices must reflect currency reali-ties if earnings are to be eventuallytransferred to the home country.C apa city utilization. A subsidiarywith excess capacity in a local mar-ket may choose to lower prices toboost demand, while tight capacitymay suggest an advantage in charg-ing higher prices.

A medium-sized MNC that hasadopted a decentralized price policyis the Taiwan-based personal com-puter firm, Acer. The home office, inLungtan, consults closely with its re-gional and country offices to deter-mine market conditions andformulate general market strategyand objectives, such as targets for netrevenue, market share and thegrowth rate for gross sales. Local dis-tributors are also encouraged andgiven autonomy to devise their ownvalue-added solutions, which allowthem in some cases to sell the sameproduct for different prices, depend-ing on the nature of the total pack-age. Acer's marketing and salesheadquarters in Taiwan providestechnical, logistical, promotional andfinance services. However, on the ba-sis of the above objectives as well ascost information provided by Lung-tan, local subsidiaries receive virtu-ally total autonomy in setting theirretail prices.

A Delicate Balancing ActHow do global corporations resolvethe conflicting needs for centraliza-tion and decentralization of pricingdecisions? Typically, the corporate of-fice sets policy and issues generalguidelines to which the overseas sub-sidiaries and distributors must ad-here. The guidelines are usuallywritten at the beginning of each fiscalyearor more often, if necessary.Pricing policies reflect both the gen-eral direction prices should take dur-ing the course of the year and thecompany's underlying global strategy.Eor instance, an American manufac-turing company's 1996 policy is thatprices are not to rise more than onepercent over 1995 prices. The com-pany adopted this policy in an at-tempt to fend off its chief rival.

Once a broad pricing strategy isset by a company's home office, sub-sidiaries and distributors are allowedto make adjustments locally becauseof the considerations listed above. Insome companies, tbe degree of pric-ing flexibility given to the subsidiaryis defined precisely. Eor example,headquarters may allow local pricesto deviate 5-15% from the centrallyestablished prices.

In practice, pricing freedom istransferred to local subsidiaries fromheadquarters through three mainmechanisms: A system of discounts on sales to in-termediate customers; Credit arrangements and terms ofsale; and Transfer prices charged to subsidiar-ies.

Exhibit 2 ou tlines tbe process ofprice determination in Kodak's inter-

national distribution channels. Theprocess includes the setting t)f keyprices at various levels in the channeland the factors which must be takeninto account at each level. Mostglobal companies start out by settinga single worldwide price, sometimesreferred to as tbe manufacturer's listprice or manufacturer's transferprice. However, the effective price orthe price charged to intermediate cus-tomers (e.g., overseas distributors, orsubsidiary) is determined by a dis-count system. Tbe discount rate var-ies for different customers andterritories on tbe basis of competitiveconsiderations, exchange rates, land-ing costs etc. The discount structure,which is reviewed frequently, thus be-comes a vehicle for transferringgreater pricing autonomy to subsidi-aries and intermediate customers.The company as a whole benefits asa result of a pricing system that is re-sponsive to local needs. Similarly,credit terms and other variable condi-tions of sale have a direct impact onthe final cost to subsidiaries and inter-mediate customers.

Einally, transfer prices charged tosubsidiaries can also be adjusted toincrease the subsidiaries pricing flexi-bility. Transfer pricing practices arediscussed later in this article.Approaches to Price SettingClearly, there is no single approachto international pricing that is bestfor every company and every situ-ation. Exhibit 3 presents one ap-proach to setting prices forinternational customers. A sequenceof key tasks are identified. What isimportant for the manufacturer to re-member is that suitability of tbeprices must be examined at severallevels in the international distribu-

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Setting of Prices at Various Levels in the International Distribution Channel: Kodak ExampleKey Steps in Price Setting Relevant Considerations

Manu facturer's Transfer Price Source of supply; costs; availability; tax rates; repatriation of earnings d ifficulties

Discount Factor (01) Relative importance of market; size of customer; nature of customer (distributor vs. subsidiary),negotiations; produrt-line considerations; competitive considerations; marketing strategy {e.g., consumerpull vs. distributor push; skimming vs. market-oriented pricing); gray market considerations; exchange rates

Factory Billing Pnce

Distributor Gross Marg in Com petitive considerations; volume and share objectives; pricing strategy (e.g., profit taking vs.pene tration); aggressiveness; suppo rt and incentives provided to retailers

Local Costs Freight, insurance, customs, duty, taxes, etc.X

Exchange Rate Adjus tmen t Inflation rate; balance of payments; deb t; govern men t policy

Distributor's Exit Price(List Price)

Value Added Tax Type of produc t, governm ent policy

Retailer's Mark-u p Going rate; com petitive intensity; incentives and support provided by distribu tor; aggressiveness; prod uct-line considerations (e.g., loss leader pricing)

Value Add ed Tax Type of product; government policy

Retaii Price

tion channelthe importer, wholesal-ers, retailers, and so on. At most com-panies a product's price starts with a"floor price," which is the lowestpossible price at which the productmay be retailed or wholesaled {de-pending on the nature of the com-pany). The floor price is derivedfrom the total cost of bringing the

product to market plus a corporatemarkup. Costs typically includeR&D., raw materials, processing,transportation, distribution, market-ing and administrative overhead.

Arriving at the correct floor priceis not as easy as it seems. As the fol-lowing examples suggest, the processis complicated because of differences

in cost accounting practices, com-pany policies (such as whether or notto factor in domestic overhead),global manufacturing and sourcingfactors, and so on. Seiko Epson, the Japanese com-puter peripherals manufacturer, setsfloor prices at headquarters after con-sidering costs, recommendations



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Exhibit 3A Decision Mak ing Framewo rk for International Pricing

Estimate the price of the product "landed " in the foreign m arketby considering international customer costs(docum entation, freight, insurance, etc.)

Estimate the price the imp orter/distributor w ill charge byconsidering tariffs and intermediary profits

Estimate target price range for end usersEstimate floor, ceiling, and expected prices

Assess com pany sales potential at given prices

Exam ine corporate goa ls and preference for pricing strategy

Select suitable pricing strategy:Rigid cost-plusFlexible cost-plusDynamic incremental

Check co nsistency w ith current price settingacross product lines, customers, and markets

Implementation:Select tactics, distribution prices, and end users prices

Monitor market performance and make adjustments as necessary

cent above or below tbe base price.Salespeople in beadquarters are al-lowed to negotiate prices withintbese parameters witb country-levelsales affiliates. In view of the rapidtechnological change and rapid entryof new products in tbat industry, tbissort of price flexibility is consideredessential by marketing staff. Hewlett-Packard leaves tbe respon-sibility for setting floor prices ("fac-tory base prices"), whicb are derivedfrom production costs, to the prod-uct divisions. In tbe pas t, factorybase prices coincided witb U.S.prices, but that is no longer the case,because of the development of over-seas production facilities and sour-cing. In calculating floor prices, acurrency differential (premium) isadded when necessary. Managementtben assesses tbe competition in ma-jor markets and builds an appropri-ate profit premium into tbe price. One U.S. manufacturing companysets the same list price (fob factory)in tbe U.S. and abroad. In arriving attbe discount structure for its dealers,tbis industrial manufacturing .MNCtakes into account tbe excbange rate,local competition and a reasonableprofit margin for tbe dealers. Finalprices, wbicb tend to be at the higbend of tbe range in each product cate-gory, also reflect sucb elements of thecompany's strengths as service, tech-nical support and a comprehensivewarranty.

from executives in tbe company'svarious manufacturing divisions andcountry markets and a corporateprofit markup target for the particu-lar product. Starting from tbis figure,product division presidents at bead-quarters establish flexibility parame-

ters. Low-end products-such as Ep-son's LQ-500 series printer-are usu-ally restricted to a variability rangeof less tban 5 percent, w hile tbeprices charged for higb-end productslike comp uters an d laser-jet p rinterscan range from 10 percent to 25 per-

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Options in Export PricingCompanies have three basic optionsin setting prices on exports (Cavusgil198S):

1 Rigid cost-plus pricing. Tbecomplexity of export pricing bascaused many managers to cling torigid cost-plus pricing, a formula tbatensures margins but may pusb the fi-nal price so high tbat the companybecomes uncompetitive lu major mar-kets. Tbe foreign list price is set byadding international customer costsand a gross margin to domesticmanufacturing costs. The final priceto tbe foreign customer includes ad-ministrative and R&D overheadcosts, transportation , insurance,packaging, marketing, documenta-tion and customs charges as well asprofit margins for botb tbe distribu-tor and the manufacturer. Cost-pluspricing is a static element of tbe mar-keting mix, since it cannot becbanged to any significant extent.

2 Flexible cost-plus pricing.This strategy sets list prices in tbesame way as tbe more rigid systembut allows for price variations in spe-cial circumstances. For example, dis-counts may be applied to the finalprice, depending on the customer, thesize of tbe otder or tbe strength of lo-cal competition. Although there ismore room to adapt export prices tolocal conditions, the primary objec-tive of tbis approacb is still to main-tain profit m argins. It, too, is thus anessentially static element of the mar-keting mix.

3 Dynam ic incremental pricing.This method assumes tbat fixed costsare incurred regardless of tbe com-pany's export sales performance.Tberefore, it seeks to recover only

variable and international customercosts in export prices while adding ina partial overhead factor rather thanthe full overhead load. This ap-proach enables the company to sellits exports at very competitive prices,perhaps enlarging its market share.

Most companies tbat use dynamicincremental pricing do so only underspecial circum stances. For ex ample,one U.S. industrial MNC negotiates"onc-sbot" deals witb its distribu-tors, offering them low prices whenit bas a sufficient quantity of theproduct, when tbe sales potential isgood or when competitive pressurenecessitates aggressive pricing.In some cases, dynamic incre-mental pricing helps a company intro-duce a product to a market. Underthis strategy, also known as "penetra-tion" pricing, the introductory, or"market floor," price is the lowestpossible. Tbe objective is to gain asmuch market share as possible in tbeshortest time. Once tbe product at-tains a sufficient market share, pricestend to increase slowly.Over tbe past few decades, Japa-

nese and Korean MNCs in particularhave successfully used penetrationstrategies in tbe U.S. and other West-ern markets, often inviting dumpingcharges by local marketers. Whencarried to extremes, however, aswhen a company charges a pricelower than the cost of making theproduct or the product's domesticprice, penetration pricing m ay runafoul of local antidumping laws, tbatare in effect in many countries.Whereas in penetration strategiesintroductory prices start low andslowly rise, in "skimming" a com-pany introduces the product into amarket at a relatively bigh price,often while limiting distribution.

This can be an effective method forlaunching innovative, bigb-techitems, such as advanced consumerelectronics devices or trendy prod-ucts. A certain segment of tbe marketwill pay premium prices to be first tohave such things, which are usuallyintroduced amid great excitement,bighly visible advertising and exten-sive media coverage. As with a pene-tration strategy, tbe price slowlycomes into line witb tbe product'sprice in other countries. Dynamic in-cremental pricing also implies skim-ming when it coincides witb adominant market share posirion, asother companies cannot afford to ig-nore the price leader's practices. Sev-eral years ago, Cummins Enginereduced its engine prices dramaticallyin Europe, the Middle East and tbeFar East to about 70 percent of itsprevious price. This strategy was suc-cessful in limiting tbe inroads madeby tbe com pany's Japanese com peti-tion.

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Transfer Pricing PracticesOne of the thorniest problems globalcompanies grapple with wben theyventure beyond tbeir bome-countryborders is transfer pricing (alsoknown as "'intracompany pricing").The prices at wbich units of the samecompany sell to each other bave a far-reaching effect on the company's suc-cess because they influenceeverything from foreign subsidiaryperformance to executive compensa-tion to tax obligations. There hasnever been a single "best" way to settransfer prices, one that satisfies bothtbe parent company and its foreignaffiliates (not to mention the tax col-lectors in all countries co ncerned).Nor does any system meet all tbeneeds of production, m arketing andfinance equally well.

Global companies attempt to man-age tbeir corporate families' internalprices primarily for two reasons.First, transfer pricing can become avehicle for repatriating profits fromtbose countries that have remittancecontrols. In the extreme case, fundsmay be blocked by tbe central bank,and transfer pricing may be the onlymeans of getting earnings out of thecountry. Second, transfer pricing canbe a way to shift profits out of high-tax countries and into low-tax ones.Underlying both objectives is the de-sire to foster corporationwide effi-ciency. While individual units maysbow poor performance, tbe com-pany as a whole can achieve optimalresults by means of careful transferpricing. For this reason, MNCs typi-cally centralize transfer pricing underthe direction of tbe cbief financial of-ficer.

Companies have available a num-ber of transfer pricing strategies avail-able. Products can be sold to

members of the same corporate fam-ily at cost or a variation of directcost, at market prices, at inflatedprices or at some combination oftbese. Some global corporations usedifferent transfer pricing metbods fordifferent purposes, accepting the costand complexity of maintaining morethan one system. Others opt for tbesimplicity of a single approach, ac-cepting the inevitable deficiencies ofwhatever system they choose. The fol-lowing are among tbe possible alter-natives. Actual cost, wbich is sometim esviewed as the absence of a transferprice, can be used for intracompanytransactions. Manufacturing facilitiesare treated as cost centers rather thanprofit centers., an approach that re-solves many internal disputes over al-location of profits. A disadvantage ofthe method is that it leaves tbe costcenters witb little inducement tomake investments, leading to addi-tional inefficiencies for the companyas a whole. Another problem is thattax authorities generally do not ac-cept this technique, unless some tax-able profits are allocated to thesupplying unit. Standard cost, unlike actual cost,has the advantage of identifying effi-ciencies or inefficiencies in the supply-ing unit. It also facilitates"management by exception" deci-sionmaking, in which variationsfrom standard cost signal tbe needfor additional investigation and atten-tion by management. A major sbort-coming is tbat standard costing oftenrequires management to make arbi-trary assumptions and leaves the com-pany vulnerable to expending timeunproductively in debates on how toset tbe standards.

Modified cost is useful in promot-ing acbicvement of strategic objec-tives. For example, actual orstandard costs arc sometimes ad-justed to encourage more extensiveuse of certain produ cts or services.Companies tbat expect to have un-used capacity for a time often lowertheir transfer prices in order to pro-vide incremental contributions to tbecoverage of "sunk" costs. Among themodifications available are variablecosts (tbose costs of materials, laborand overbead that vary directly withthe number of units produced), mar-ginal costs [the costs of producingone more unit) and full absorptioncosts (costs that would not change ifsales to other business unitsstoppedfor example tbe cost ofshared factory overhead). Market price. Prevailing externalmarket prices (arm's-length prices)are often viewed as the best transferpricing mechanism for external re-porting. Because this approach re-moves internal bias and facilitatesvalidation, it appeals to outside par-ties, such as tax authorities. From aperformance evaluation perspective,however, market prices may be unfairbecause they give the supplying busi-ness unit the entire profit on thetransaction, including the benefit ofany cost reductions due to global effi-ciencies. To equitably sbare tbe ad-vantage of lower costs, transferprices must be lower tban marketprice. Modified market price. Marketprices can be adjusted to reflect spe-cific characteristics of the goods orservices involved. For example, theymay be reduced to reflect lower mar-keting or distribution costs tbat oc-cur in external markets. Ordinarily,

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this will help resolve perceived inequi-ties among supplying and receivingbusiness units. However, a supplyingunit that has no excess capacity willstill feel unfairly penalized if thelower price cuts into tbe profits theunit would otberwise earn on exter-nal sales. In sucb a case, tbe externalprofit is a relevant opportunity costand it should be factored into thetransfer price. Negotiated prices are determinedby bargaining between the buyingand selling units. Although some ex-ecutives may argue that this tech-nique results in an arm's lengthtransaction that is just as valid as anexternal market price, its use in evalu-ating the performance of subsidiarieshas some risks. For instance, negotia-tors may fail to reach agreement,wbicb could result in counterproduc-tive and expensive procurement ofgoods and services from outside thefirm. Another problem is that exces-sive internal competition can under-mine the achievement of congruentgoals among business units and re-sult in a serious loss of cooperation. Co ntrac t price. A variation of thenegotiated price method is a priceagreed upon at the time the firm'sbusiness plan is adopted. Such a"contract" price eliminates vari-ations that result from centralizedsourcing decisions beyond tbe con-trol of managers of foreign opera-tions. One drawback of the m ethodis that it does no t pass on price bikesin raw materials to marketing units.As a result, it removes the marketingunit's incentive to recover any infla-tionary and foreign excbange lossesthrough third party pricing.

How do global companies chooseamong these transfer pricing possibili-

ties? Many factors are involved in de-ciding wbicb transfer price to useand wbether to use different pricesfor reporting external and internalperformance. Sometimes on e issue isof overriding importance to a com-pany, clearly dictating a particularpricing system. More often, however,a company's situation is mixed, mak-ing the choice highly complex andprobably contentious. For most com-panies, the decision involves somecombination of tbe considerationsdiscussed below: Local taxes. Perhaps the mo st sig-nificant concerns in setting transferprices are the local tax rate and perti-nent tax regulations. The use of trans-fer pricing to sbift profits into localjurisdictions tbat have relativelylower corporate tax rates normallyresults in lower o verall income tax es.However, higb prices for capital as-sets increase tbe depreciation allow-ances for the business units thatreceive them. This lowers overalltaxes when the assets are transferredfrom lower- to higher-rate jurisdic-tions.

An effective transfer pricing sys-tem sbould deal with changes in im-port-export duties, income taxes,excise taxes, etc., in a way that mini-mizes these taxes overall.

Generally, lower transfer pricesmean lower levies; prices in excess ofcertain thresho lds may result inhigher import duties, especially ifthey are assessed on an ad valorembasis. Similarly, keeping transferprices low can reduce local value-added taxes. VATs are based on thevalue added within tbe taxing juris-diction and are factored into theprice at the next sales level.

Currency fluctuations. Transferprices can be adjusted so as to bal-ance the effect of fluctuating curren-cies when one subsidiary operates inan environment of low-level inflationand another in a climate of ramp antinflation. Subsidiary profits. Still another useof transfer pricing is to manipulatethe profit position of a subsidiary.For example, startups often requiresubstantial corporate assistance,whicb can be provided in tbe form oflower purcbase prices from or highersales prices to other company units.In this way, a market niche can becarved out more quickly for tbestartup and its long-term survivalguaranteed. Expense accounting. Transferprices can also be used to advantagewben tbe host government poses re-strictions on allowable deductionsfor expenses. Sometimes certain serv-ices, such as product development orstrategic planning assistance, are pro-vided to the subsidiary but cannot becharged because of restrictions. Intbat case, costs for those services canbe recouped by increasing the trans-fer prices of components sold to theunits. Joint venture support. Similarly,transfer pricing can help recoup ex-penses from a joint venture, espe-cially if there are restrictions onrepatriation of profits. Lowering theprices of products and services to aparent reduces the outflow of fundsfrom the home country, while raisingthe prices of purchases from the par-ent shifts funds to the home country.When government imposes localprice controls, transfer pricing prac-tices may again help. Higher transferprices on exports of intermediate

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How Transfer Pricing Can Help Maximize Corporation-wideReported Earnings

Sellscost plus

Subsidiary A is likely to be in a country that has: Low corporate income tax Higb tariffs Favorable accoun ting rules for calculating incom e(e.g. allowable deductions) Political stability Little or no restrictions on profit re patriation Strategic importan ce to company

goods from a parent to a subsidiaryin sucb a market may help supportthe case for an increase in tbe priceof tbe final product. Output capacity. Subsidiaries withsubstantial excess production capac-ity can set transfer prices low enoughto encourage add itional internal con-sumption but high enough to covertbe supplying unit's variable costs.

Exhibit 4 illustrates graphicallytbe dynamics of transfer pricingamong tbe members of tbe corporate

family. In tbis illustration. SubsidiaryA is considered a "favored" subsidi-ary since it is allowed to source at alow cost and sell at a high pricewhen transacting with other subsidi-aries. Tbe corporate reasons for thisare also outlined.

As implied by the above discus-sion, tbe ability to control internalprices cbarged to subsidiaries affordsthe global corporation significantflexibility and overall efficiency. Nev-ertbeless, these benefits often come ata cost. First, tbere is tbe complication

of internal control measures. Manipu-lating transfer prices makes it verydifficult to determine the true profitcontribution of a subsidiary. Second,morale problems typically surface ata subsidiary whose profit perform-ance bas been made worse artifi-cially. Tbird, because of culturaldifferences, some subsidiary manage-ment's may react negatively to pricemanipulation. Fourth, there is theconcern over local regulations. Sub-sidiaries, as local businesses, mustabide by the rules. Legal problemswill arise if tbe subsidiary follows ac-counting standards that are not ap-proved by tbe host government.Indeed, in many countries, transferpricing practices are often subject toclose review by local authorities.ConclusionUndoubtedly, pricing will continue togain significance for global compa-nies over the next decade. Witb inten-sified competition andinterdependence of markets, globalmanagers will find management ofprices even more cballenging. Thechallenges will involve attainment ofbetter coordination of worldwideprices by corporate headq uarters,achievement of the delicate balancebetween corporate and local controlof prices, quicker response to market-place changes, avoidance of gray-market or parallel-importing activityand development of alternatives tooften costly price competition.

These challenges imply new or im-proved practices on the part ofglobal companies. For example, an ef-ficient, smooth and rapid system ofcommunication with subsidiary man-agers or distributors is essential.Tbose companies tbat operate in socalled global industries, sucb as tele-

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comm unications, construction equip-ment, or medical equipment, need todevise efficient mechanisms for moni-toring competition worldwide anddisseminating relevant informationto the members of tbe corporate fam-ily in a timely manner.Pricing globally also remains anorganizational cballenge. Increas-ingly, it is an area in which inputfrom different functional divisionsand regions allows for better deci-sionmaking. Nevertheless, many com-panies make critical pricing decisionswithout the necessary consultationwith all units concerned.

Pricing executives will also baveto develop a better appreciation oftbe intimate relationships betweenprice and other elements of the mar-keting mix. Pricing decisions cannotbe reacbed in isolation from otber di-mensions of the offer, such as prod-uct quality, after-sale service,follow-up sales opportunities, creditterms and so on. Price representsonly one item in the bundle of bene-fits perceived by the customer. Inter-preting customer's perception ofproduct value continues to be a for-midable bur necessary task. Pricingdecisions tbat are based on a good

understanding of perceived value-from the perspective of both the inter-mediaries and the finalcustomersare more likely to be suc-cessful.Acknowledgment: This article isbased partially on the author's earlierwork which appeared in a corporatereport. Marketing Strategies forGlobal Growth and Competitive-ness, New York, NY: Business Inter-national Corporation, 1990, .57-70,

ReferencesCavusgil, S. Tamer (i9S8}. "LInraveling the Mys-tique of Export Pricing, ' Business Horizons 3 1 ,N o , 3 (May-June 19881:54-63.

Cavusgil, S. Tamer and Ed Sikora (1988). "Ho wMultinacianals Can Counter Cray Market Im-por ts , " Columbia Juurnal of World Business 23 ,No. 4 (Winter 1988), 75-86.

Reirmaii, Valeric (1996]. "Japan is Aghast as For-eigner Takes rhe Wheel at .Mazda," Wall StreetJournal, 15 April.



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Reading-Pricing for Global Markets