Market Minus Pricing for transfer pricing and better market insights
Market-minus pricing helps businesses get a much greater sense of urgency and market awareness. It is also a method of transfer pricing which offers sound justification, and is an option for international businesses looking to minimise tax. When used for transfer pricing, market minus shifts profit towards the entity which holds the most added value. I had a role in implementing it at a global manufacturing businesses, primarily as a transfer pricing method. It profoundly changed the way the sales units understood profitability.
When used as a pricing method for better decision making, market-minus pricing has tremendous benefits for companies facing new competitors and economic change. Price signals are like the central nervous system of an animal: they transmit information to the brain. Market-minus is better than cost-price-plus for this vital job. Market-minus is also known as price-down or price-minus.
Market minus pricing is a transfer pricing method alternative to the usual cost-price plus approach used by multi-site and international businesses. Transfer pricing can be used by any organisation that wants to split profit accountability between 'production' units and sales and marketing units. It also has tax implications, which for this article are a secondary issue.
Used properly, market-minus imposes market disciplines on manufacturing and supply units. Market-minus pricing can help an organisation adapt to a period of disturbance, new entrants and severe price erosion. This was my experience at Philips Lighting in Europe when Chinese competitors emerged quickly and the Euro entered a sustained period of strength.
How does market-minus differ?
Usually, production units determine product costs, and charge that amount to sales and marketing units ("commercial" units). If international boundaries are involved, the cost price is based on standard cost, and a profit margin is added so that some tax is paid in the country where the factory is. This is of course a budget process, with assumptions made about volumes. These assumptions are agreed to by the commercial units or deployed by senior management.
Commercial units see this is a cost price (although a more sophisticated system may at least remove the fiscal margin). It's up to the commercial units to sell at a profit starting from the factory price. This is the cost-price-plus approach
The problem with cost-price-plus in a time of competitive change
Cost-price plus assumes the industrial and sourcing side of the business are competitive. Commercial units are signalled to take what they're given, and extract money from the market. The factory units are guaranteed profits assuming that volumes are reached, and if volumes are not reached, everyone knows where the fault lies: with the commercial units.
There's a theoretical problem with this model, and there's a practical problem. The two are linked.
The theoretical problem with cost-price-plus
A firm makes profit because it adds value. Value is added according to the risk taken (to keep it simple). The riskiest part of a vertically integrated manufacturing business is where the long-term money is, and that's in manufacturing, with its expensive fixed assets and punts on innovation and new technologies. Yet the market minus model makes the commercial units responsible for making the profit, since the factories get a fixed income. That's upside down.
The practical problem with cost-price-plus
The practical problem is related. If a manufacturing firm loses its added value to a serious extent, it won't be because the latest advertising campaign failed. It will be because the factories are being out-competed, whether by new competitors, new technology, shifts in the market or even sustained exchange rate changes. Unfortunately, cost-price-plus obscures this life-threatening problem, since it is the commercial units which fail to meet targets as market prices fall due to economic and competitive changes. Cost-price-plus reveals the pain, but in the wrong place.
Enter market-minus
Market-minus pricing turns the whole process upside down. In the budget phase, market prices are determined (based on current experience and supplemented with market drivers, which may be GDP growth or market research). Commercial units are challenged on their commercial costs, which are usually easier to understand than manufacturing costs. These costs are subtracted from the forecast sales figure, and a fiscal margin is built in. Finally, this is put into a calculator with a product mix, and transfer prices per product (or product family) are calculated. Even a large business can do this with Excel. The factories then face a market-related income level. A large business will have different factories making different products. Market-minus shows each factory the market situation of its product range. If emerging competition is harming one factory more than another, the truth of the market situation is much clearer than in the cost-price-plus model, which averages too much.
Implementation tips: margin awareness
Above, I mentioned the theoretical point that factories are where the profit is really made for a capital-intensive manufacturer, because that's where the financial risks are taken. However, it is the commercial units which set prices and do the selling; they have to realise the added value of the business. So they need to know the true costs and margins of what they are selling. Under cost-price-plus, they had an approximate view: the transfer prices. Under market-minus, the transfer price tells them nothing. So a market-minus implementation must give commercial units true-cost price information. This is an opportunity to provide modern, cash-costs to commercial units. It is probably a big project, and a big part of the change to market minus. Done right, this will be a huge benefit.
Evaluation
Based on a European-wide implementation of market-minus pricing in a business which was (and is) number 1 in its sector (Philips Lighting), market-minus pricing prepared manufacturing and sourcing units for what was to become a traumatic period of economic change. It transmitted the reality of front-line change from the large markets of Western Europe to the factories in regional and Central European locations. In a large and slow moving company, market-minus pricing contributed enormously to building a sense of urgency and connection to the market. An equally powerful benefit was the forced start-from-scratch cost price information. Stripped from the burden of meeting fiscal requirements, cost price data was liberated from a crude fully-absorbed standard cost price and became a commercially-oriented data set which enabled much faster and more accurate decisions making in the commercial units. Tenders and contracts which would previously have been walked away from became genuine profit-making opportunities.
Note: fiscal considerations (international taxation)
Most taxation authorities respect transfer pricing which follows OECD definitions of being "third-party" or "arm's length" pricing. When a company buys from a subsidiary across international boundaries, there is obviously not a genuine third-party relationship, so OECD guidelines, and international practice, have established how to arrive at acceptable pricing. It comes down to documentation. As long as market minus pricing follows a clear process which offers no special treatment from one country to the next, and which is consistently applied, and as long as it is well documented and based on reasonable costs, it will be acceptable. Because it moves profits (or losses) to where economic risk is taken, it is actually more objective.
For more information
Tim Richardson helped implement market minus pricing for Philips Lighting in Europe. As Financial Controller and then Finance Director, he travelled to commercial units explaining the changes, assisted in designing the pricing tools and developed the new cost price databases. He had European commercial responsibilities during the design and roll-out, and was promoted to industrial responsibilities after the change went live.
For more information, please contact Tim Richardson on +61 423 091 732 or +61 3 8678 1850