Dissertation transfer pricing

A GROUP DECISION SUPPORT SYSTEM
FOR TRANSFER PRICING
IN THE PHARMACEUTICAL INDUSTRY

A GROUP DECISION SUPPORT SYSTEM
FOR TRANSFER PRICING
IN THE PHARMACEUTICAL INDUSTRY

PROEFSCHRIFT

ter verkrijging van de graad van doctor
aan de Technische Universiteit Delft,
op gezag van de Rector Magnificus,
Prof. Drs. P.A. Schenck,
in het openbaar te verdedigen
ten overstaan van een commissie
door het College van Dekanen daartoe aangewezen,
op dinsdag 12 september 1989 te 16.00 uur

door

MICHAEL BARTHOLOMEUS MARIA VAN DER VEN

geboren te Goirle

TR diss
1749

Dit proefschrift is goedgekeurd door de promotor:
Prof. Dr. H.G. Sol

Promotiecommissie

Prof. Dr. H.G. Sol, Technische Universiteit Delft, promotor
Prof. Dr. A. Bosman, Rijksuniversiteit Groningen
Prof. Drs. B.K. Brussaard, Technische Universiteit Delft
Prof. Dr. H. Koppelaar, Technische Universiteit Delft
Prof. Dr. F.A. Lootsma, Technische Universiteit Delft
Prof. Dr. Ir. CA.Th. Takkenberg, Rijksuniversiteit Utrecht
Dr. H.C. Verlage, Raad van Bestuur Grasso's Koninklijke Machinefabrieken NV

"Transfer pricing in pharmaceuticals
is more of an art than a science"

Otto Nowotny

The writing of this thesis is in gratitude
dedicated to my wife Eugenie, my parents
and my parents-in-law.

Published and distributed by:

Michael van der Ven
p.o. Mosheuvel
Molenbochtstraat 76
5014 ER Tilburg
The Netherlands
Tel. +31(13)365309 or +31(13)359429

Cover:
Piet van Zwieten

Print:
Gianotten BV, Tilburg

The following names are registered trade marks:
Comshare
IBM
Lotus 1-2-3
MAUD
MS-DOS
Personal Wizard
System W

The author was supported by a grant under the Ministry of Education "National
Facility for Informatics" programme (project NFI-1).

CIP-DATA, Koninklijke Bibliotheek, The Hague
Ven, Michael Bartholomeus Maria van der
A group decision support system for transfer pricing in the pharmaceutical industry /
Michael Bartholomeus Maria van der Ven. - [S.l. : s.n.]. - 111.
Thesis Delft. - With index, ref. - With summary in Dutch.
ISBN 90-9002887-0
SISO 385.9 UDC 681.3:[338.5:334.71:615.2](043.3)
Subject heading: group decision support systems / transfer prices / pharmaceutical
industry

ISBN: 90-9002887-0

© 1989 by M.B.M. van der Ven

All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without written permission of the author.

Contents

1 BACKGROUND AND RESEARCH QUESTIONS 1
1.1 Introduction 1
1.2 Research questions and research approach 4
1.3 Outline of the thesis 9

2 THE EUROPEAN PHARMACEUTICAL INDUSTRY 11
2.1 Introduction 11
2.2 Some characteristics of the European pharmaceutical industry 12
2.3 Relationship with national health organizations 15
2.4 The approach of the British National Health Service 16
2.5 Conclusion 21

3 TRANSFER PRICING: A COMPLEX ISSUE 23
3.1 Introduction 23
3.2 Management-control transfer pricing 23
3.3 International transfer pricing 29
3.4 Transfer pricing in the pharmaceutical industry 38
3.5 A framework to describe transfer pricing 40
3.6 Conclusion 43

4 GROUP DECISION SUPPORT SYSTEMS 45
4.1 Introduction 45
4.2 Structuring decision processes 47
4.3 Multi-criteria decision making 54
4.4 Approaches to group decision support systems 56
4.5 Four aspects of developing group decision support systems 61
4.6 Conclusion 64

5 TRANSFER PRICING AT EUROPHAR: THE PROBLEM 67
5.1 Introduction 67
5.2 Europhar: the company 69
5.3 Decision process before system introduction 73
5.4 Descriptive empirical model 78
5.5 Descriptive conceptual model 81
5.6 Conclusion 85

6 TRANSFER PRICING AT EUROPHAR: A SOLUTION 87
6.1 Introduction 87
6.2 Prescriptive conceptual model 87
6.3 Prescriptive empirical model 107
6.4 Decision process after system introduction 116
6.5 Conclusion 135

vu

7 EVALUATION 137
7.1 Introduction 137
7.2 Questionnaire and answers 141
7.3 Overall evaluation 147
7.4 Conclusion 151

8 SUMMARY AND CONCLUSIONS 153
8.1 Summary of findings 153
8.2 Future research 155

REFERENCES 157

List of exhibits 165

Samenvatting in het Nederlands 167

Acknowledgements 171

List of contributing institutions 172

About the author 172

Index 173

viii

1

BACKGROUND AND RESEARCH QUESTIONS
1.1 Introduction
As a result of the post-war expansion of foreign direct investments, trade is
increasingly dominated by multinational companies, so called "multinationals". An
increasing part of this trade is intra-firm trade in the sense that the seller and buyer
belong to the same multinational group of companies.

According to Murray [1981, p. 2] around 40% of the exports of multinationals based
in the major Western industrialized countries were intra-group transfers and these
figures are rising. According to the report of the Independent Commission on
International Development Issues, intra-firm trade makes up over 30% of all world
trade, see Brandt et al. [1980, p. 188]. Although these figures should be handled with
care, they give a good indication. Besides the internal sales of goods, other transactions
take place extensively between the different parts of these enterprises, for example the
granting of loans, the licensing of technology and the provision of services. The price
which is set for the transfer of goods and services between two companies belonging
to the same group, is called "transfer price". For the purpose of this project, a more
specific definition will be introduced in chapter 3. "Transfer pricing" is defined as the
process of deterrnining transfer prices. It is related to decision making.

Within large multinational companies, decentralization is necessary as centralization of
decisions at headquarters would become counterproductive: it would overtax the time
and energy of top management. The background of transfer pricing can be found in
this decentralization principle in decision making, see chapter 3. Sheer size and the
resulting complexity of multinationals argue against centralized management. Secondly,
vesting the decision-making responsibility with the local manager allows for a more
flexible response to local circumstances which can vary enormously, see
Plasschaert [1979, pp. 23-24].

Decisions concerning transfer prices may reflect legitimate business concerns of a
company, but they are also capable of being used in order to shift profits from high
to low tax countries or to get around exchange or price-control regulations. Such
practices; although pursued in the best business interest of a company, may conflict
with the interest of host countries. This is not to suggest, according to Brandt et
al. [1980, p. 189], that as a class, multinationals have been using such practices.
Plasschaert [1985, p. 263] states that, with regard to over- and underpricing the
evidence is meager and he points to the dangers of undue generalizations. He protests
against the connotation that multinationals "are the villains" and points to the
sometimes negative effects of government measures concerning transfer prices.

Nevertheless, caused by the increased size of intra-company trade of multinationals and
the negative publicity on the subject in the seventies, see for example Vaitos [1974],

1

BACKGROUND AND RESEARCH QUESTIONS Ch. 1

government interference has increased. So the multinational has to operate in an
increasingly strict legal framework which has remained national. It has therefore to
conform with the varied and sometimes conflicting national laws in countries in which
it operates, see OECD [1979, p. 7]. The increased governmental interference in its turn
causes a growing interest in the various aspects of transfer pricing from business as
well as from governmental side.

In order to demonstrate the complexity of the issue, literature on international transfer
pricing often presents examples from the pharmaceutical industry, see for instance
Verlage [1975] and Plasschaert [1979]. According to Nowotny [1987] and Von
Grebmer [1987a], transfer-pricing problems are especially poignant for the
pharmaceutical industry. This is caused, amongst others, by their relatively high degree
of internationalization in combination with centralized production and research facilities.
In other words: high centralized costs need to be covered by international intra-
company sales. The position of the pharmaceutical industry will be explained in more
detail in chapter 2.

In all phases of the decision process, the problem of international transfer pricing,
especially in the pharmaceutical industry, is considered to be highly ill-structured.
Sol [1982, p. 5], discusses various definitions of ill-structuredness. One of these
definitions is taken from Uhr [1973, p. 274]: "Ill-formedness in problems seems to be
closely related to issues of vagueness, ambiguity, flexibility, and creativity about all of
which little is known." With Sol, Takkenberg [1983a, p. 10] notes that many the existing
definitions of ill-structuredness are vague. To avoid ambiguity, we use the definition of
Sol [1982, p. 5]. Sol starts with the definition of a well-structured problem: "A problem
is well-structured if the following conditions are met:
1. the set of alternative courses of actions or solutions is finite and limited,
2. the solutions are consistently derived from a model system that shows a good
correspondence,
3. the effectiveness and efficiency of the courses of action can be numerically evaluated"
Problems that do not fulfil these requirements are defined as ill-structured.

In literature on decision support, many authors have stressed the importance of
supporting decision making with regard to ill-structured problems. Attempts at
supporting decision making in ill-structured problem situations have focused on the
development of so called "decision support systems". The aim of these systems is the
use of computers to aid decision makers, see Sol [1985b] and Bosman [1987a].

During the last decade, decision support systems have gained dramatically in popularity.
Research on decision-making and decision support systems has increased likewise, see
McLean and Sol [1986]. According to Sol [1987b, p. 203], experiences with decision
support systems are not always positive: "... [We] observe that empirical evidence on
the effectiveness of decision support systems is not overwhelmingly positive, and often
conflicting", see also Sol [1987a]. On the basis of laboratory experiments, Van
Schaik [1988, p. 127] concludes that "teams using a decision support system do not
perform better than those without."

2

Sec. 1.1 INTRODUCTION

With reference to DeSanctis and Gallupe [1985] we define a decision support system
as an interactive computer-based system which facilitates solution of ill-structured
problems. Not that this definition does limit itself to computer support only: other
elements of the organization, like data, procedures and organizational members can
also be included, see also Bots and Sol [1988].

Confining ourselves to the pharmaceutical industry, we see the following: on the one
hand, we have an ill-structured problem of increasing importance to the pharmaceutical
company, namely international transfer pricing. On the other hand we have a relatively
new research area, namely decision support systems. We expect that decision support
systems are useful for determining international transfer prices within the
pharmaceutical industry.

As will be explained in more detail in chapter 2, the environment of the
pharmaceutical industry is complex, hostile and turbulent, especially with regard to
transfer pricing.

The environment is complex as many actors are involved: consumer groups, various
governmental bodies from many countries, supra-national organizations like the World
Health Organization and the European Community, health insurance companies and
last but not least the competition. The high degree of internationalization and the
division between prescribing, using and paying for drugs are amongst the causes of the
complexity of the environment.

Hostility of the environment is not only caused by the competition but also by the
groups that oppose current price levels and international price differences. According
to De Jong [1981] "the industry, which earlier contributed to the conquest of many
diseases, is no longer in favor with the general public", see also Breuk [1985]. It is
under scrutiny from health-care authorities and consumer groups. Books with titles like
"Corporate crime in the pharmaceutical industry", see Braithwaite [1984], give an
impression of the hostilities the industry has to face. In the book we just mentioned,
a special section is dedicated to transfer pricing.

The environment is turbulent as constantly new regulations are issued by the authorities
involved. The developments with regard to the common market and changing measures
with the aim to contain health care costs are examples, see Scrip [1988]. Moves of
competitors also need to be monitored closely.

According to Huber and McDaniel [1986, p. 577], complexity, hostility and turbulence
are the three main characteristics of the organizational environment in the post-
industrial society. For this kind of environment, Huber and McDaniel propose the
"decision-making paradigm". Like Simon [1973, pp. 269-270], Huber and McDaniel
consider decision making as the organization's central activity. In view of this,
improving decision making in organizations should be the focus of attention of the
organizational sciences. According to Huber [1984a, 1984b], one of the elements that
can contribute to improved decision making of post-industrial organizations are so-

3


called "group decision support systems". These are decision support systems explicitly
designed to be used by groups of decision makers.

With regard to transfer pricing, pharmaceutical companies find themselves in a
complex, hostile and turbulent post-industrial environment. Following Huber, group
decision support systems should be useful in such a setting. In other words, transfer
pricing in the pharmaceutical industry seems a "perfect" example to test the concept
of group decision support.

To put it more formally: it is our hypothesis that group decision support systems are
helpful for improving decision making with regard to the determination of transfer
prices in the pharmaceutical industry.

1.2 Research questions and research approach
In this section, we cover some issues that are related to our research approach.
According to Fitzgerald et al. [1985, p. 5], information technology is still so new, that
not one adequate research approach for scientific progress exists but that pluralism
needs to be accepted. Our basic presumption is that these fundamental issues must be
answered within the context of a particular research setting. That is to say, a research
approach is neither appropriate nor inappropriate until it is applied to a specific
research problem, see Downey and Ireland [1979, p. 630]. This holds also for the two
research questions which we try to answer. These research questions are:

A: What are the characteristics of a group decision support system designed to support
and improve organizational decision making with regard to transfer prices within the
pharmaceutical industry?

B: What are the effects of the use of this designed group decision support system on
decision making within the organization?

Following Huber and McDaniel [1986], we consider decision making as the
organization's central activity. In the literature, various approaches towards decision
making exist. One of these approaches is based upon "bounded rationality", see
Sol [1982, p. 7].

In our research approach we take the paradigm of bounded rationality as point of
departure. This implies that we do not presume that decision makers have all relevant
information and an unlimited capacity to process this information. Our point of
departure is that decision makers operate "in their own environment with own
definitions and limited scopes on accessible data", see Sol [1982, p. 7]. Simon [1976,
pp. 65-86] considers behavior bounded rational "when it is the outcome of appropriate
deliberation. [Bounded rationality] depends on the process that generated it." Discussing
bounded rationality, Takkenberg [1983a] states that "it is impossible to define
unambiguously what is rational. ... Rational is now also determined by the multitude
of circumstances that influence the decision maker".

4

Sec 1.2 RESEARCH QUESTIONS AND RESEARCH APPROACH

In order to determine the multitude of circumstances that influence a decision maker,
we need to analyze the existing situation, see Bosman [1986, p. 315] and
Takkenberg [1983b, p. 258]. On the basis of this analysis, we make a description of the
decision process, as it takes place. We define this description of the "as-is" situation
as the descriptive empirical model, see also Sol and Van der Ven [1989]. This model
is descriptive in the sense that the actual ("as-is") situation is described. No normative
elements are included. This first model is empirical in the sense that it describes an
actual situation which exists within one specific organizational group. Names of
organizational members, financial figures and other specific details will be included. On
the basis of one or more descriptive empirical models, a descriptive conceptual model
is constructed. This descriptive conceptual model is "data void", see Bosman and
Sol [1985, p. 82]. This model is still a description of the "as-is" situation, but now at
a higher level of abstraction: the essential characteristics of the various empirical
models are transformed into a possibly more generic description which provides global
insight in the existing situation. The level of abstraction is such, that this model can
be used for other organizations which are in a similar position.

On the basis of this latter descriptive model, literature research and other explorations,
a third model comes into existence: the prescriptive conceptual model. The prescriptive
conceptual is a combination of "description and design principles", see Bosman [1987b,
p. 32]. It is prescriptive in the sense that it contains normative elements, see
Takkenberg [1983a]: using this model for decision making should lead to an improved
decision process.

When elaborating on our first research question, we will determine three of the four
model categories as presented in exhibit 1-1. In this exhibit, the numbers 1-4 indicate
the order of the activities that we follow. These four activities precede the construction
of the corresponding model.

descriptive prescriptive
model model
1: 4:
empirical data collection implementation
model concerning the of the improved
existing situation model

2: 3:
conceptual abstraction analyses and
model improvement of
the model

Exhibit 1-1. Categories of models.

The prescriptive conceptual model is our answer to the first research question.

In order to elaborate on the second research question, we need to perform a test in
the form of experimental use of the system. Experimental use of the system requires

5


the set up of one or more empirical models on the basis of the prescriptive model
that we designed. This latter model is defined as the prescriptive empirical model. The
use of this empirical model in the daily practice of a pharmaceutical company provides
the desired insight on the effect of the group decision support system on decision
making. By means of analysis of the effect of the prescriptive empirical model, we
evaluate our prescriptive conceptual model.

Now we explained various categories of models, we can rephrase our two research
questions:

A': What are the characteristics of the prescriptive conceptual model?

B': What are the effects of the use of the prescriptive empirical model on organizational
decision making?

With regard to organizational decision making, Mintzberg [1979, p. 584] states the
following: "...It seems that the more deeply we probe into this field of organizations,
the more complex we can find it to be, and the more we need to fall back on so
called exploratory, as opposed to 'rigorous' research methodologies." To obtain a
prescriptive conceptual model, Mintzberg [1979, p. 587] proposes research within one
organization, sometimes even for years, as: "We need to be 'in touch'. Increasingly in
our research we are impressed by the importance of phenomena that cannot be
measured: by the impact of an organization's history and its ideology on its current
strategy, by the role that personality and intuition play in decision making. To miss this
in research is to miss the very lifeblood of the organization. And missed it is in
research what by its very design, precludes the collection of anecdotal information."
DeSanctis and Gallupe [1987, p. 593] propose longitudinal research specifically for
research in the area of group decision support systems. Our research activities should
be regarded as one of the "pilot testing" activities, see DeSanctis and Gallupe [1985,
p. 8], that are required to progress in the area of group decision support.

We explicitly choose to answer these questions by means of a real-life case study, see
Sol and Van der Ven [1988a]. This choice is based upon the following considerations,
see Benbasat et al. [1987]:
- little research exists which integrates all aspects of international transfer pricing,
- the project has a revelatory character, see Yin [1984, p. 47] as not much is known
about the way transfer-price decisions are taken in practice,
- as improvement of "real-life" decision making is one of the aims, close cooperation
with the industry is imperative.

It should be realized that "case study" as used above does not mean that the
researcher is watching the organization from the sideline. He is actively involved in the
design of the prescriptive conceptual model and should be regarded as a member of
the organization.

In order to analyze the existing situation with regard to transfer pricing and to test a
pilot system, we decide to cooperate with a large pharmaceutical company for a period

6


of five years. For the definition of "large pharmaceutical company" in this respect, see
Van der Ven [1989a]. In this thesis we name this company "Europhar". In research
terms, five years is a relatively long period of "on-site" analysis. Our research is of an
explicit exploratory nature.

On the basis of this on-site research, the descriptive empirical model and the
descriptive conceptual model will be created. In general, decision makers do not know
how they reach a decision. Usually, they only know the outcome, the decision itself.
Therefore the descriptive conceptual model will be based on long "on-site" observations,
direct involvement in organizational activities, open interviews and video-taped meetings.

The exploratory approach that we choose to follow is described by Conklin [1968, p.
172] as involving "a long period of intimate study and residence in a well-defined
community employing a wide range of observational techniques including prolonged
face-to-face contact with members of local groups, direct participation in some of the
groups activities, and a greater emphasis on intensive work with informants than on the
use of documentary or survey data".

Strong involvement in an organization, however, will not be sufficient for the
development of a prescriptive conceptual model. It is necessary to observe the
organization from a (mental) distance as it "would hardly be a fish who discovers the
existence of water", see Wolcott [1975, p. 115]. For us, the involvement in literature
research will provide this distance. Literature research will be concerned with the areas
of transfer pricing and decision support. Information on the pharmaceutical industry
will be gathered.

On the basis of literature research and the descriptive conceptual model, we will
design a prescriptive conceptual model. Based on this latter model, a prescriptive
empirical model for one subsidiary company of Europhar will be made.

This prescriptive empirical model should be regarded as an experimental system and
not as a full system, see Keen [1986, p. 51]. Our explicit aim is to demonstrate the
feasibility of the group decision support approach for international transfer pricing. The
development of the experimental system is regarded by Europhar as a low-risk research
and development venture, especially as a substantial part of the costs are borne by
various Dutch research institutions. Such an experimental "version 0" is defined by
Keen [1986, p. 50] as "an initial small system which is complete in itself, but may
include limited functional capability". The aim of the system, in our case the
prescriptive empirical model, is to establish the value of the proposed concept.

For this experimental system, we need to select one subsidiary of Europhar
International. For reasons discussed in chapter 5, Europhar UK Ltd in London will
be selected. In the research project decision making concerning Europhar UK plays
a dominant role and will be described in detail, see exhibit 1-2.

7


information description
on the transfer- decision- decision
pharmaceutical pricing support process
industry literature literature Europhar UK
(before)

descriptive
empirical
model
Europhar UK

descriptive
conceptual
model

prescriptive
conceptual
model

question A': what are the characteristics of the prescriptive
conceptual model?

question B 1 : what is the impact of the prescriptive empirical
model on organizational decision making?

information ''
on
Europhar UK prescriptive
empirical
model
Europhar UK

''
description
decision comparison
process
Europhar UK
(after)

Exhibit 1-2. Overview of the research approach.

8


It should be realized that the analysis of various other decision situations, for European
as well as for third-world countries, will contribute to the construction of the
descriptive conceptual model, although they will not be described in detail.

The "real-life" use of the experimental system (after implementation for the UK),
together with the description of the already existing decision-process (before
implementation for the UK) will form the basis for the evaluation.

1.3 Outline of the thesis
This thesis can basically be divided into two parts: the chapters 1 to 4 provide a
theoretical background. In the chapters 5 to 8, the Europhar case study is discussed.
The outline of the thesis is as follows:

In chapter 2 we discuss the pharmaceutical industry. It is explained why we limit
ourselves to the European pharmaceutical industry.

In chapter 3, we explain the research limitation to international transfer pricing. We
will introduce a framework for analyzing financing and transfer-pricing issues.

In chapter 4, backgrounds, possibilities and recent developments in the area of group
decision support systems are discussed. The possibilities are related to transfer-pricing
problems and lead to the design guidelines of the prescriptive conceptual model.

In chapter 5, we present the Europhar company and describe the descriptive empirical
and conceptual model.

In chapter 6, we discuss the design of the prescriptive conceptual and empirical model.
In this chapter, the use of the experimental system during six months is discussed.

In chapter 7, various approaches to the evaluation of information systems are discussed.
Interviews are the main basis of the evaluation of the pilot system. Outcome of the
interviews and anecdotal evidence are discussed.

Chapter 8 presents the conclusions and possible areas for future research.

The pharmaceutical industry, transfer pricing and group decision support are in itself
complex issues. In the chapters 5, 6 and 7, these three areas come together in the
descriptive models, the prescriptive models and the evaluation. For a proper
understanding of what is presented in these chapters, the background knowledge as
presented in chapters 1 to 4 of the thesis is essential.

9


10

2

THE EUROPEAN PHARMACEUTICAL INDUSTRY
2.1 Introduction
As stated in the previous chapter, we limit ourselves to transfer-pricing problems for
the following category of multinationals:

The European-based innovative pharmaceutical industry which develops, produces and
sells human ethical drugs.

All aspects, of this limitation are now described below. We shall explain the rationale
behind this limitation.

"Human ethical drugs" are drugs intended for human use. Use by the patient is only
allowed upon a prescription by a medical practitioner. This in contrast with so called
"over the counter" drugs like Paracetamol. For over the counter drugs, no prescription
is needed. By this limitation, veterinary products are also excluded. We limit ourselves
to this part of the pharmaceutical industry, as interference by governmental health
care organizations is especially intense for these kinds of products. As will be
explained in this chapter, governmental interference in this area influences transfer-
price decisions.

With "Europe" in this respect, we mean all countries that participate in the European
federation of pharmaceutical industry associations "EFPIA". Besides the current member
countries of the European Community (except Luxembourg), Austria, Finland, Norway,
Sweden and Switzerland participate in this organization, see EFPIA [1987]. By
"European-based" companies we mean those companies which have their headquarters
in Europe. As far as the pharmaceutical industry is concerned, outside Europe, only
Japan and the United States need to be considered, see IMS [1988]. We exclude these
non-European based pharmaceutical companies as decision making may be different
due to sharply different circumstances on the home market. This holds for both Japan
and the United States, see Burstall [1985, pp. 125-127] and Reinshagen [1988]. In
general, it can be said, that the Japanese and American firms have another approach
to decision making than European firms. This is due to cultural differences, see
Nath [1988]. It is possible that these cultural differences influence vital presumptions
of our approach, like team setting. (Team setting will be discussed in more detail in
the next chapter).

That we decided to include all European countries is because of the information we
received from the European-based industry. Like Burstall [1985, p. 2], we noted that
European companies are more "notable for their degree of uniformity than divergence".
Partially, information on the industry was systematically gathered, see Van der
Ven [1989a]. For another part, we received feed-back in informal contacts with industry
representatives during company visits, conferences and alike. It is interesting to note

11

THE EUROPEAN PHARMACEUTICAL INDUSTRY Ch. 2

that Nath [1988] treats European firms as one class. This in spite of the differences
that exist within Europe.

The limitation to innovative companies excludes those companies which only produce
and sell so-called "generics". Generics are drugs which are usually sold under a
chemical name instead of under a brand name. They are copies of good selling human
ethical drugs developed by innovative pharmaceutical companies. These copies are
brought on the market after the patent period is expired. As for the generic producers
the product and the market are already developed, marketing and research expenditure
are much less than for the research-based industry. In this chapter we shall explain
how high fixed marketing and research costs influence organizational decision making.
The exclusion of generic producers, however, does not imply that innovative companies
never produce and sell generics. The difference with non-innovative companies is that
generics only form a minor part of their sales. Within innovative companies sales of
generics contributes to research cost.

To give a global impression of the size of the pharmaceutical industry in EFPIA
countries, the following figures for 1986 are presented, see EFPIA [1987]:
- production: 43,000 million ECU,
- employment: 450,000 people.
(In the beginning of 1986, the value of the ECU was 2.46 Dutch guilders.)

When in the remaining part of this thesis we discuss "the European pharmaceutical
industry", we mean those companies as indicated by the description above.

2.2 Some characteristics of the European pharmaceutical industry
Lorsch and Lawrence [1970] demonstrated the interaction that exists between
organization and environment leading to the contingency (or situational) approach to
organizational design. As environmental characteristics may influence the organizational
structure of a company, market structure, governmental interference and cost structure
will now be discussed.

Market structure: separate therapeutic areas
The pharmaceutical market is in itself subdivided into many self contained therapeutic
areas, see Burstall [1985, p. 5]. For instance, in 1985 the Dutch market was divided
in 24 submarkets which each contained between 2% and 7% of the market, see
Nefarma [1985, p. 18]. Examples of these submarkets are the market for psychotropics
and the market for anti-asthmatics. Diversification within the industry is low as a
company needs to concentrate on one or a few of these therapeutic areas. Following
Eccles [1985, p. 272] we use the term diversification to refer to the number of different
businesses in which the company competes and how different these businesses are from
each other. Costs of finding and developing a new drug are extremely large, according
to Von Grebmer [1987b] about 100 Million ECU for every newly-introduced
medicament. According to Von Grebmer [1987b], there are technical and economic
limits to decentralization of these research activities. This centralized research

12

Sec. 2.2 SOME CHARACTERISTICS OF THE PHARMACEUTICAL INDUSTRY

expenditure is directed to one or a few therapeutic areas and this expenditure can only
be recovered by sales on this small part of the total pharmaceutical market. This
implies that the submarket needs to be covered worldwide to recover research costs.
Hence, strong internationalization is a common characteristic of these pharmaceutical
companies. It should be realized that size and other characteristics of a certain part
of the market may vary widely depending on the country and the therapeutic area that
are serviced. In 1982, for example, over 40% of sales from the pharmaceutical industry
of the European Community was realized outside the common market, see
Burstall [1985, p. 115].

Governmental interference
Due to the involvement of governmental authorities in health-care matters, sales of
pharmaceuticals is subject to an "unusual degree of government regulations", see
Burstall [1985, p. 14]. Despite a general tendency towards deregulation, recent trends
do not point to any significant reduction in the stringency of drug regulations, see
Hansen [1987].

Pharmaceuticals are closely linked to the issue of human health care, which is
considered to be one of the prime governmental responsibilities. Many of these
regulations are related to the drug safety and efficacy issues. Human health care is
very sensitive as far as public opinion is concerned. The issues at stake require careful
distribution and monitoring. This implies that the distribution of pharmaceutical
products cannot be delegated to a third party with the instruction to "just get the
product sold". Should something go wrong, hostile publicity and legal pursuits would
force the company involved in a difficult position. Therefore strict control on quality
and logistics is needed. Secondly, training and instruction of representatives is of vital
importance to assure proper use of new and existing products. Well trained
representatives are important to assure two way communication between the industry
and prescribing doctors, which is necessary from a marketing as well as from a
medical point of view, see ABPI [1985, p. 32]. Regulations require, for example, that
the company that develops, produces and sells a drug keeps closely in touch with the
market in order to pick up any adverse drug reactions (post-marketing surveillance).

To assure this proper two way flow of information between the parts of the company
that are in touch with the local market, and the head office, a strong "vertical
integration" is needed. Following Eccles [1985, p. 272] we use the term vertical
integration to refer to the inclusion of activities within the firm that could be obtained
externally, such as raw materials, distribution channels and staff services. So within the
pharmaceutical industry one finds that fundamental research in search for a new
product as well as the final instruction of medical professionals in a remote country
is done by people of the same multinational company within a framework of strict
control to the board of management, see also Von Grebmer [1987a]. This strict control
reinforces centralization.

Regulations do not only pertain to registration of new products or quality control
matters. Price regulations are involved as well. This will be discussed in the next
section.

13


Cost structure: high fixed costs
According to Von Grebmer [1987b, p. 233 and 234], "knowledge of the specific cost
structure of the research-based companies is the key to understanding their market
behavior when considering their pricing strategies ... On average, not more than 30
percent of the cost can be allocated directly to individual products, the remaining costs
and the profit margin have to be covered by contributions from total sale of the whole
product range." In other words, judgement of profitability of a pharmaceutical company
should take place at the aggregate, total company, level and not on the disaggregate,
individual product, level. Selling prices at the disaggregate level are unavoidably based
upon a more or less arbitrary allocation of fixed costs.

As the relatively high fixed costs are made anyway, the total financial contribution that
a local marketing subsidiary brings in, is of greater importance than its local net profit.
So it is vital that the energy of the sales force is spent on the sales of in-house
developed products and not on the sales of other products which might produce, in
the short run, better results for one local subsidiary of the company. This cost
structure contributes to a high vertical integration and centralization of decision making.
In other words, within the industry, the delegation of power and responsibility to lower
organizational levels (decentralization) is relatively limited.

The various items discussed above, make up the organizational environment for the
European pharmaceutical industry and determine the main characteristics of the
industry: strong internationalization and centralization, strong vertical integration and
low horizontal integration, see also Von Grebmer [1987b, p. 240]. In exhibit 2-1, we
present the structure of a typical pharmaceutical company. The arrows indicate the
flow of goods.
management center
parent shareholder
company supplier
research center

national
border <...other subs
companies
<' ''
subsidiary subsidiary marketing company
company company

Exhibit 2-1. Organizational structure of a typical pharmaceutical company.

The parent company takes care of research, production, financing and marketing
support. The parent company is the shareholder of the local subsidiary. The main
task of the subsidiary company is to market the drugs, which are developed and

14

Sec. 2.2 SOME CHARACTERISTICS OF THE PHARMACEUTICAL INDUSTRY

produced by the parent company, on the local market. (Other words for subsidiary
company are "local company" or "daughter company").

2.3 Relationship with national health organizations
Governmental interference in the supply of pharmaceuticals takes place in many
countries all over the world, see for example Bouee [1987] and PBPA [1988]. In this
section we will discuss the developments within Europe as an example. This is because
Europe constitutes the home market of the industry.

In the European pharmaceutical market, a three-tier demand system exists: the
physician prescribes the product, the patient uses it, and national health organizations
pay the bill.

Background of the increasing interference in pricing of pharmaceuticals is the aim to
contain health-care costs. Health-care costs are in most countries a part of collective
expenditure, which in general suffer from large deficits. This pressure from public
health services is a matter of great concern to the industry as "control over aspects of
pharmaceutical company operations do not in general result from a considered view
of the industry as a whole", see Burstall [1985, p. 14]. Governments and the European-
Community authorities are under pressure of consumer groups to force down prices,
see for example BEUC [1984]. In the annual report of the Netherlands-based
multinational Akzo [1985], this concern is expressed as follows:

"The need for constructive talks between authorities and innovative pharmaceutical
companies is growing. As we have argued on previous occasions, there is an
ever-present danger that, in their understandable desire to control expenditures, the
authorities will accept the prices charged by the producers of generics (drugs not
protected by patents and trademark registration) as the bench mark for national health
insurance payments. Were they to do so, there would be little or no margin left to
conduct time- and money- consuming research for the new, better drugs so urgently
needed. Such research, after all, is funded out of the revenues generated by the sale
of established products. While this issue especially concerns the industry, it is also a
significant public health matter. We are prepared to join with the authorities in looking
for ways to reconcile these divergent objectives".

Within Europe, various ways to control prices exist. A basic difference between these
price-regulation schemes is their approach to the issue of aggregation and
disaggregation. Aggregate level price-regulation schemes control total-company profit of
a specific subsidiary company. The disaggregate level pricing schemes control prices by
fixing the selling price of individual pharmaceutical products. For an overview of the
various approaches, see Van Cayseele [1987].

In view of the realization of the European common market, initial steps with regard
to harmonization of the pharmaceutical market are being made by the European
Commission. First aim of the Commission is to clarify the rules that are issued by

15


the various member states. As far as reimbursement systems are concerned, these
attempts stress above all the importance of transparency in the operation of national
systems so that importers can verify that objective criteria are genuinely being applied
and all relevant factors are being taken into consideration by member states. Given the
different medical traditions of the member states, however, the European Community
authorities realize that it would appear unrealistic to seek to lay down a completely
harmonized community price structure for pharmaceuticals, see Hankin [1988].

Besides the transparency in procedures followed by member states, a first step is
made to increase transparency on prices themselves. By the European Commission, a
database will be set up which, amongst others, contains ex-factory and retail prices, see
EG [1989]. Although the registration of transfer prices was considered by the
Commission, it was decided that these would not be included in the database as
transfer-pricing information was considered to be of a confidential nature.

The involvement of a multi-state framework like the European Community in
pharmaceutical pricing and reimbursement issues, poses additional problems for the
industry. The directive concerning transparency represents only the start of a much
wider debate on pricing, transfer pricing and reimbursement. The industry is, on the
one hand, still faced with individual sovereign governmental policies. On the other hand
it is confronted with a multi-state framework committed to the goal of a unified
market, see Owen [1988].

2.4 The approach of the British National Health Service
In the previous section, governmental interference with (transfer) prices has been
discussed globally. In this section, one price-regulation scheme is worked out in more
detail to provide insight in the practical consequences of such a scheme for the
companies involved. We choose the British scheme as, according to Burstall [1985, p.
152], "there is a general feeling among the major [European] drug companies that, if
prices must be controlled, then the British system is the most acceptable. It also
commands interest and respect in official circles elsewhere."

The scheme is limited to branded human ethical drugs paid for by the National Health
Service (NHS). Generics are excluded. For further details see DHSS [1986]. The main
purposes of the NHS scheme are to:
- secure the provision of medicines for the National Health Service at reasonable
prices,
- to promote a strong pharmaceutical industry capable of sustained research
expenditure.
Note that "reasonable prices" are not the only aim of the scheme. The NHS authorities
(the "Department of Health and Social Security") also act as sponsor for the industry,
on behalf of the British government. Aspects that are relevant for the authorities as
part of their "sponsor" responsibilities are the size and quality of employment in the
United Kingdom and the size of exports. According to the Association of British

16

Sec. 2.4 THE APPROACH OF THE BRITISH NATIONAL HEALTH SERVICE

Pharmaceutical Industries, for example, recent changes in the regulations encourage the
development of research and production facilities in Britain, see Scrip [1987a, p. 5].

The "Pharmaceutical Price Regulation Scheme" provides a set of regulations for the
calculation of profit (the "Annual Financial Return"). This profit calculation forms a
basis for negotiations between each individual pharmaceutical company and the NHS
authorities. Focal point is the profit that the company makes on sales to the NHS. The
NHS-profit calculation of each company needs to be completed annually and submitted
to the NHS authorities. All costs claimed are examined critically by the health service.
In principle most of the costs are allowed, but there are however some special
constraints. If the health service considers that profits of a company are excessive
under the terms of the price-regulation scheme, price reductions or cash repayments
are sought to the extent necessary to reduce profit to an acceptable level. The
negotiations between pharmaceutical companies and the authorities have been described
as "tough but fair", see Scrip [1987b, p. 2]. The target profit on which price increases
or repayments are based, are established by taking the average return on capital of
British industries in other public sector business, like aircraft-building companies. This
target profit is influenced by the state of the public finances and subject to negotiation
with each individual company.

NHS sales
-- transfer prices (landed costs)
-- manufacturing costs
-- manufacturing overhead
gross margin
-- distribution costs
-- information costs
-- promotional costs

operating performance
-- royalties
-- general overheads
profit before interest and taxation

Exhibit 2-2. First part of the NHS-profit calculation.

Usually the target profit is expressed as a return on capital. This return on capital is
the focal point during the negotiations between the authorities and the individual
company. If the actual return on capital is greater than the target, defined as an
"excess", a repayment to the NHS might be the consequence. In case the actual return
on capital is smaller than the target, defined as a "shortfall", a price increase might be
the consequence. The calculation basically exists of three parts:
- calculation of the "profit before interest and taxation", starting from the NHS sales,
- calculation of the "total adjusted profit", starting from the profit before interest and
taxation,
- calculation of the "excess/shortfall on the target return on capital", starting from the
total adjusted profit.

17


The global outline of the first part of the NHS-profit calculation is presented in exhibit
2-2.

In exhibit 2-2, the sign "--" stands for "minus". The gross margin, for example, is
calculated by subtracting transfer prices (or landed costs), manufacturing costs and
manufacturing overhead from the NHS sales. We presume that lump-sum royalties are
paid to the mother company and the mother company is the only supplier. All figures
are expressed in British pounds sterling (GBP). This set of figures is made up for
NHS sales as only these sales are controlled. Generic sales in Britain or exports are
excluded in the profit calculation. When costs are directly related to activities (like
distribution, information and promotional costs), there is no need for allocation. In
cases that costs cannot be precisely apportioned between NHS sales, generic sales and
exports, an artificial cost allocation has to be made. Possible bases for allocation are:
- net sales,
- local manufacturing costs (added value),
- costs of goods (costs of goods equal the sum of landed costs and local
manufacturing costs).
The first step of the NHS-profit calculation is to calculate the gross margin. The
distribution, information and promotional costs are subtracted from the gross margin
to obtain what is defined as the operating performance.

The scheme makes a strict distinction between allowable and non-allowable costs.
Allowable information costs include for example expenses on samples for identification
purposes and medical symposia. Allowable promotional costs include among others
literature, representatives, administration and advertising. Gifts are not allowed as a
promotional cost on the profit calculation.

Both royalties and general overheads are subtracted from the operating performance
to obtain the profit before interest and taxation. The authorities are only interested in
the profit before interest and taxation. The companies are not allowed to include
taxation costs and interest costs in the profit calculation because the different financing
structures of the companies would distort the comparison between companies.

Now follows the second part of the NHS calculation. The profit before interest and
taxation, as calculated above, is the basis for the calculation of the "total adjusted
profit" as presented in exhibit 2-3.

profit before interest and taxation
+ add-back injected costs
+ add-back promotional costs
-- export discouragement correction

total adjusted profit

Exhibit 2-3. Second part of the NHS-profit calculation.

18

Sec. 2.4 THE APPROACH OF THE BRITISH NATIONAL HEALTH SERVICE

An add-back for royalties and transfer pricing (defined as add-back injected costs) is
added to the profit before interest and taxation, when the sum of transfer prices and
royalties exceeds a certain percentage, considered acceptable by the NHS, say x%. In
this case the NHS authorities consider the "injected costs" (cost transferred from the
mother company) too high and demand a correction on profit before interest and
taxation. So the formula for the add-back is as follows:

add-back injected cost =
(allocated royalty + NHS transfer price) -- x% of NHS sales

Here we can clearly see how transfer pricing decisions and regulations of health-care
authorities interfere: the value of the add-back on injected cost equals the difference
between transfer prices added to royalties and x% of the total net sales. This x% is
a negotiated figure and differs per company. It is important to note that there exists
only an add-back for transfer prices and royalties. Where the local picture does not
satisfy the authorities, they then consider the consolidated picture. If, however, the sum
of transfer price and royalties is lower than the negotiated percentage, no action is
taken. In other words, there is no symmetry in the approach of the authorities in this
respect. They only adjust the figures where this is to their advantage.

Say, for example, that a British subsidiary of a multinational company has liquidity
problems and that a transfer-price decrease is considered. In case this company should
decide to lower the sum of transfer prices and royalties to a percentage lower than
the agreed x%, it artificially increases its profits. This high profit could ultimately result
in a repayment to the national health service. This example clearly illustrates the
interference of transfer-price decisions with health care regulations.

The NHS sets a maximal sales-promotion allowance. Not only are some costs
unacceptable, when a company spends more then this allowance, the amount overspent
(add-back promotional costs) has to be added to the profit before interest and taxation.
Also a cash repayment of the amount overspent is requested. For more details on the
background of this punishment for overspent promotional costs, see Haayer-Ruskamp
and Dukes [1986].

A strict apportionment of capital and costs between home and export markets may in
some circumstances produce an unfair result. High export sales may result in a smaller
part of capital allocated to the NHS. This is called the export discouragement (or
"disincentive"). As on the other hand, the authorities are concerned with balance of
payments and employment effects, a correction mechanism is applied. So an export-
discouragement correction is deducted from the profit before interest and taxation. A
special set of rules exists for the calculation of the correction.

19


The concepts used in the third and final part of the NHS-profit calculation are:
- negotiated target return on capital, percentage,
- average capital employed (NHS sales), in GBP,
- average capital employed (total), in GBP,
- actual return on capital, percentage,
- excess/shortfall on target, in GBP.
The first step is to calculate the actual return on capital. The size of the acceptable
return on capital earned by individual companies on NHS sales is a matter of
negotiation with the NHS authorities. The negotiated target return on capital depends
on the nature and scale of the company's relevant investment and activities and the
associated long-term risk. Eventually the negotiated target return on capital is assessed
by the authorities.

In order to obtain the actual return on capital first the average capital employed for
NHS sales has to be calculated. The sum of the net-capital employed on the opening
and the closing balance sheet is divided by 2 to obtain the total average capital
employed. The average capital employed for NHS sales is calculated by allocating the
total average capital employed according to one of the allocation methods mentioned
earlier in this section. The actual return on capital (ROC, sometimes also called "return
on investment") is a division of the total adjusted profit by the average capital employed
for NHS sales multiplied by 100. In formula:

total adjusted profit
actual ROC = * 100%
average capital employed (NHS sales)

The excess or shortfall on target can now be calculated by subtracting the negotiated
return on capital multiplied by the average capital employed for NHS sales from the
total adjusted profit. In formula:

excess/shortfall =
total adjusted profit -- [negotiated ROC * average capital employed (NHS sales)]

This final excess/shortfall calculation is not only influenced by the levels of transfer
prices. Changes in royalty payments, changes in intracompany payment terms and
intracompany cost charges also influence the excess/shortfall. This implies that of all
these financing instruments, the impact on the profit calculation needs to be
determined.

In this section we explained the British price-regulation scheme. Their approach to
pharmaceutical pricing is one amongst many, both within Europe and worldwide. In
most countries, Eke in Britain, interaction exists between transfer pricing and
reimbursement. By means of the example given above, we demonstrated what such a
relationship might look Eke. All transfer-pricing issues that relate to the relationship
with the health-care authorities, wiU be referred to as the commercial aspects of
transfer pricing.

20

Sec. 2.5 CONCLUSION

2.5 Conclusion
Three conclusions can be drawn from this chapter.

In chapter 1, we stated that the pharmaceutical industry finds itself in a complex,
hostile and turbulent environment, see Huber [1984b], certainly as far as pricing and
transfer-pricing issues are concerned. In this chapter we elaborated on this statement.

Secondly, great similarities exist in the way European pharmaceutical companies
operate. As the environment of the industry is for an important part determined by
governmental regulations and interest groups, the environment is alike for most
companies. As a consequence, many European pharmaceutical companies are structured
in a similar manner. This similarity is confirmed by the research of Burstall [1985] and
by our own experience, see Van der Ven [1989a]. This conclusion is of relevance when
possibilities for a more general use of the prescriptive conceptual model will be
discussed in chapter 8.

Thirdly, the European pharmaceutical industry can be described by the following
characteristics: a high degree of internationalization and centralization, a high degree
of vertical integration and a low degree of diversification. These characteristics are
relevant for our discussion of the various approaches to transfer pricing in the next
chapter.

21


22

3

TRANSFER PRICING: A COMPLEX ISSUE
3.1 Introduction
Transfer pricing is a subject that seems favorite amongst economists, as an abundance
of literature can be found, see for example Eden [1985], Kassicieh [1985] and
Hirschleifer [1956]. Not only scientists like the subject. Transfer pricing appears to be
a rather preferred choice of masters-degree students in economics, see for example
Mostermans [1982] and Van der Plas [1983]. It struck us that so many of these
publications seem irrelevant for the problem at hand. Although a profound ability in
mathematical modeling is demonstrated, practical relevance for our analysis is small.
As will be discussed in section 3.2, the publication of Rasch [1980] is a notable
exception. In general, scientists are aware of this limitation, see for example
Meijboom [1986].

Transfer-pricing studies that provide a picture of most aspects involved are for example
Verlage [1975], Plasschaert [1979] and Krens [1979]. The relevant aspects can be
divided into two categories. The first category deals with what is defined as
"management-control" issues, see Krens [1979]. Planning of corporate resources and
performance measurement are the two main aspects of management-control transfer
pricing. These will be discussed in the next section. The second category is of
importance in the case of international transfers and is concerned with international
financing, tax issues, duties, foreign-exchange controls and alike. These will be discussed
in section 3.3. Pharmaceutical price-regulation schemes as discussed in chapter 2 are
related to this "international" aspect. In section 3.4 we will apply the various concepts
to the situation in the pharmaceutical industry.

In the remaining part of the thesis we decide to concentrate on transfer prices for
goods. Transfer prices for services are excluded. As will be explained in section 3.3,
this is not to say that payments for services, like management fees and royalty
payments, do not relate to the transfer-pricing problem, see also OECD [1979].

3.2 Management-control transfer pricing
For a better understanding of management-control transfer pricing, we should go back
to micro-economic theory. According to Adam Smith, individuals should pursue then-
own interest and by doing so, they promote the interest of society, see Landreth [1976,
p. 39]. Presuming competitive markets, individuals are led by an invisible hand when
pursuing their own interest, according to Adam Smith. This invisible hand leads
individuals by means of prices for goods, services, capital and labor. As stated in
section 3.1, we concentrate on the prices of goods.

23

TRANSFER PRICING: A COMPLEX ISSUE Ch. 3

A relatively high price for a good that an individual produces and sells, leads to a
relatively high income and hence to relatively high spending power. In other words, the
individual is rewarded by society for offering goods that are relatively scares. Below,
we will relate this aspect to "performance measurement".

This rewarding mechanism influences the decision that the individual makes: he will
plan the use of his resources in such a way that he is able to offer those goods on
the market that are relatively scares. Below we will relate this aspect to "planning".

It should be realized that above, we only discussed external prices. External prices that
are set between independent parties operating on their own behalf on a competitive
market. We now discuss the use of a price-mechanism for use within large
organizations.

According to Chandler [1977, p. 1], modern business enterprises partially "took the
place of market mechanisms in coordinating the activities of the economy... In many
sectors of the economy the visible hand of management replaced what Adam Smith
referred to as the invisible hand of market forces". Cause of this replacement,
according to Chandler [1977, pp. 6-7], is that modern companies "... continued to grow
by setting up or purchasing business units that were theoretically able to operate as
independent enterprises - in other words, by internalizing the activities that had been
or could be carried on by several business units..." From the point of view of the
organization, a side-effect of this growth is an increase in management problems.

Allocating limited resources to alternative uses can be expressed as a mathematical
problem for which various formulations and solutions exist. In case of linear constraints
and a linear target function that expresses company objectives, linear programming can
be used, see Lee and Shim [1986]. As Bosman [1977] and Verlage [1975] explain,
detailed knowledge on all units which constitute the organization is required for
successful use of this technique. All technical parameters, for example, should be
known. If this approach is followed, an optimal solution is presented allocating the
resources to the final products. Given this solution, so called "shadow prices" of the
resources can be calculated. Both Bosman [1977, p. 241] and Verlage [1975, p. 185]
reject the use of shadow prices as a coordination mechanism for large complex
organizations.

An alternative approach to the problem of allocation of resources is divisionalization,
combined with the "right" transfer prices. Divisionalization can be defined as
decentralization plus delegation of divisional profit responsibility to lower organizational
levels at which decision making also exists, see Verlage [1975, p. 5]. Splitting up in
divisions is an attempt to combine many of the advantages of a big company with
many advantages of a small one. Such a system replaces detailed planning and
evaluation decisions by top management. Another possibility which will be discussed
later in this section, is to split up an enterprise into smaller units without strictly
adhering to the profit-center concept. Transfer pricing that is related to
divisionalization issues is defined as "management-control transfer pricing", see
Krens [1979].

24

Sec. 3.2 MANAGEMENT-CONTROL TRANSFER PRICING

Transfer-price decisions have great influence on the distribution of profit of the
divisions involved. Take for example a multinational A. X and Y are two divisions of
A, each with own profit responsibility. The intermediate product z is produced by X
and then sold to Y. When the transfer price of product z is increased, the divisional
profit of X will increase, to the expense of Y's divisional profit. Divisional management
considers the maximization of its own divisional profit as its main target. The divisions
"compete" with each other to obtain the highest divisional profit. As the divisional
management is judged (and compared) on the basis of this divisional profit, a shift of
cost is of great importance to divisional management. So a correct approach to transfer
pricing is a prerequisite to make the profit-center concept work.

According to Verlage [1975], a transfer-pricing policy should serve the same two roles
that are performed by external prices: performance measurement and planning. From
a point of view of profit measurement (ex post), transfer prices must ensure that
divisional profit, as it is measured, is the same as the controllable profit for all
divisions involved. So divisional profit should not be influenced by decisions taken by
other divisions and reflect only the impact of decisions made by the own division. A
transfer price which possesses this quality is defined as "neutral". From a planning
point of view (ex ante), transfer prices must ensure that, when divisional management
bases its decisions on these prices to maximize its own divisional profit, the profit of
the enterprise as a whole is maximized. A transfer price which possesses this quality
is denned as "optimal". Verlage [1975] concludes that a transfer-pricing policy based
on market prices is the only system that meets both requirements. A prerequisite for
such a system, however, is that a competitive market for intermediate products exists.

The concept discussed above deals with a really divisionalized enterprise. We now
turn to another approach. It is possible that decision making in the organization takes
place by means of teams and that no internal competition between divisions exists. This
approach of decision making in groups relates to the "behavioral theory of the firm",
see Verlage [1975, p. 19]. According to the behavioral theory of the firm, company
goals are the result of interaction between organizational members. Rasch [1980, p. 65]
defines a team as a group of people with a common goal. People at different positions
within the organization may have different information and hence may take different
decisions based on that information, but there is no incentive problem. There is no
conflict of interest between team members. Under the condition of team setting, the
transfer-pricing policy does not have an impact on company goals. Rasch's proof of
this statement is of a mathematical nature. Under the premise that the individual
decision maker has knowledge of the impact of his decision on the organization as a
whole, the transfer price is an internal mechanism for the firm and as such it has no
impact on the overall objectives. This result can be anticipated by the realization that
the decision makers are attempting to achieve corporate objectives which are derived
from an overall perspective based on external (market) conditions. The internal transfer
price is merely a means for liquidity transfer and does not affect the performance of the
organization as a whole. The decentralized team-decision policy is independent of
transfer pricing and the determination of a transfer-pricing policy should not be based
on its effect on the decentralized decision-maker's actions, according to Rasch.

25


Rasch [1980, pp. 100-103] even states that, given team setting, the expenses involved
in working out a transfer-pricing policy may be avoided and an increase in efficiency
might be realized.

Several approaches to planning and performance measurement exist. The
"divisionalization" approach discussed above takes divisional profit as the central item
and a guideline for divisional decision making and performance measurement. The
"team setting" approach as described by Rasch [1980], takes the concept of teamwork
as the central means to achieve company goals.

On the basis of empirical research, Eccles [1985, p. 274] relates these two approaches
to company and market characteristics, see also Lorsch and Lawrence [1970].
According to Eccles, the transfer-pricing policy depends on the type of organization
and, consequently, the environmental setting in which the organization finds itself. The
two main factors which determine the transfer-pricing policy according to Eccles, are
vertical integration and diversification.

The term vertical integration refers to the inclusion of activities within the firm that
could be obtained externally, such as production of raw materials, distribution channels
and staff services. Vertical integration creates mutual dependencies between the various
units like divisions, corporate line management and staff functions of the enterprise.

The term diversification refers to the number of different businesses (or markets) in
which the company competes and how different these businesses are from each other.
The larger the number of products and markets in which a company competes, the
greater the diversification, according to Eccles. In exhibit 3-1 three types of company
are shown.
A
high x X
(cooperative) (collaborative)

degree of
vertical
integration

low x
(competitive)
I ^.
low degree of high
diversification
Exhibit 3-1. Eccles' contingency approach to management control.
Of these three types, two are relevant for our research: the cooperative and the
competitive type. These will now be discussed in more detail. The following
descriptions are based upon Eccles [1985, pp. 276-277].

26


The cooperative organization
The cooperative organization is high on vertical integration and low on diversification
and has its focus on a small line of products. This organizational type is often found
in capital-intensive industries. The term cooperative is used to indicate that decision
making within this firm is focused on cooperation among all managers to "maximize"
total company performance. The strategy for this type of company is a strategy for the
company as a whole, with all decentralized strategies being expressed in terms of their
contribution to it. The narrow product focus results in the company being organized
as one single profit center. Management-control systems distinguish functional
responsibilities in terms of costs, revenues, and physical units. Great emphasis is placed
on using internal standards and historical results in evaluating performance. The high
interdependence across the various units (for example, manufacturing and sales)
requires substantially subjective judgment on the part of general management in
evaluating performance, since high interdependence makes divisional profit an imperfect
measure. The processes between superiors and subordinates are very much top-down
because of the focus on a narrow range of products and the interdependence across
units. Horizontal processes for conflict resolution aim at expertise sharing and finding
common interests. In other words, units seek to find a solution that is in the best
interest of the company as a whole. Top management exercises control on the actions
of lower-level managers primarily through the organizational structure. Control over
actions is necessitated by the high degree of interdependence caused by vertical
integration. It is possible to have such control because of top management's experience
in and detailed familiarity with the narrow range of businesses in which the company
is engaged. Because of the high degree of interdependence, lower-level managers are
rewarded in terms of their contribution to the performance of the company as a whole.

The competitive organization
The opposite of the cooperative organization is the competitive organization. The
competitive type is high on diversification and low on vertical integration. Its structure
is based on many different businesses that do little sharing of such resources as
manufacturing facilities and sales forces. This organizational type is exemplified by
conglomerates or holding companies. The term competitive is used to indicate that the
subunits of this organization are profit centers and compete with each other for capital
and other resources on the basis of performance. Performance is comparable across
all subunits, unlike the case of the cooperative organization. Corporate strategy in the
competitive firm is largely an aggregation of subunit strategies, such as those of
divisions. Although broad strategic guidelines might exist for the company as a whole,
they are not nearly as important in developing subunit strategies as they are in the
cooperative organization. Competitive firms employ a multi-divisional structure,
supplemented by systems that measure the profitability and return on investment of the
divisions. As a result of the high degree of decentralization of authority and
responsibility, vertical processes are bottom-up - initiated by lower-level profit-center
managers when they want assistance from top management or corporate staff. The
horizontal processes of conflict resolution are characterized by negotiation, in which
each party attempts to maximize his own share in the context of fixed-sum payoffs. In
other words, profit centers seek to maximize their own results even at the expense of

27


other profit centers. The emphasis is on using financial measures, like divisional profit,
to evaluate performance. Top management must exert control primarily through the
measures of financial outcomes, since it cannot know each of the company's many
businesses in sufficient detail to deal more directly with operating concerns. The
lower-level general managers are rewarded in terms of the performance of their
divisions.

The empirical research undertaken by Eccles [1985] shows that depending on the type
of company (competitive or cooperative) a different approach to transfer pricing exists:

The cooperative type of company often uses full-cost transfer prices. A full cost price
includes both variable and fixed-cost elements. An example is provided by means of
the following formula for the transfer price of intermediate product z:

transfer price = variable cost + x% of fixed cost

The x percent serves to allocate fixed overheads. The percentage of x is determined
by means of dividing the budgeted fixed cost for the coming period by the "normal
size" of the production, see Van der Schroeff and Groeneveld [1980] and
Bosman [1977]. Following Bosman [1977, p. 258], the term "allocation" should in this
respect be interpreted as "a more or less arbitrary apportionment of cost, which results
from planning activities". Transfer prices determined by means of full costing are not
very useful instruments in the area of management-control transfer pricing. Therefore,
little effort is made to identify responsibility for variances. The performance of each.
profit center affects, and is affected by, the performance of others. A full-cost transfer-
pricing approach is neither "neutral" nor "optimal" as defined earlier in this section.

The distinctive characteristic of cooperative kind of companies is the low level of
conflict that exists. This is because of the high level of cooperation among the
managers involved. All are focusing on objectives at a level higher than their own unit.
In all cases, subjective judgment is important in evaluating and rewarding the
performance of these managers, since divisional profit is an imperfect indication of
their contribution to the company as a whole.

For this type of company, Verlage [1975, p. 188] proposes consolidated, and not
divisional, profit measurement to determine the performance of divisional management.
Detailed budgets should be used for planning purposes. This means, in practice, that
profit responsibility is replaced by responsibility for much more detailed budgets, which
are stated in terms of volumes, cost, etc. According to Bosman [1977, pp. 241-242],
these budgets are determined by means of negotiations between top management and
lower management levels. A good management information system is a prerequisite for
detailed budgeting procedures and consolidated performance measurement.

According to Eccles [1985], the competitive type of company uses transfer prices based
upon market prices of the intermediate product that is sold between the divisions.
Inter-divisional transactions only occur when they are agreed upon by managers in both

28


the buying and selling division. The distinctive characteristic of the competitive type of
company is that there are discouragements to trade internally. This problem results
from the pressures placed on profit-center managers to achieve financial objectives and
from their awareness of the difficulties internal transfers could create for them in
inhibiting their ability and authority to achieve these objectives. Because they are
evaluated and rewarded primarily in terms of divisional profit, they have little incentive
to cooperate with other divisions.

The distinction between the cooperative- and the competitive type companies, as
developed by Eccles, is useful for our research. However, as Eccles [1985, p. 273]
states, any actual organization can be composed of several of these types. Relations
between divisions, for example, could be identified as competitive as a high degree of
diversification and a low degree of vertical integration exists. One of the divisions, say
division X, might consist of various decentralized units. Relations between the
decentralized units within division X could be identified as cooperative as a low degree
of diversification and a high degree of vertical integration exists. Consequently, the
transfer-pricing policy should be set in accordance with the different structures in the
different parts of the company. In chapter 6, the Europhar case will illustrate this
issue.

3.3 International transfer pricing
In the previous section the management-control aspects of transfer pricing have been
discussed. In a multinational enterprise, however, another aspect is also of great
importance.

As the transfer price is the price for which the product crosses the national border,
the height of the transfer price has, among other things, consequences for the
international distribution of funds and profits, corporate taxes paid in various countries
and import duties. We define transfer pricing based on these considerations as
"international transfer pricing" to distinguish it from transfer pricing for management-
control purposes. Note that this definition has a wider scope than the term "fiscal
transfer pricing".

While discussing multinationals, the OECD report on transfer pricing [1979, p. 7]
states: "... Such an international economic entity generally operates in a legal framework
which has remained national; it has therefore to conform with the varied and
sometimes conflicting national laws [and other regulations] of the countries in which
it operates." A group of Dutch transfer-price experts concludes that fiscal and other
authorities should be reticent in their requirements towards the multinational because
in the area of transfer pricing it is difficult to qualify prices as "right" or "wrong", see
Vereniging van Belasting Wetenschappen [1987, p. 65]. As an illustration, we now
present some of the issues that may be at stake, see also Vereniging van Belasting
Wetenschappen [1987], OECD [1984], Verlage [1980] and Plasschaert [1979]:

29


- A company in country A bought from its subsidiary in country B at a price which
was too low, according to the customs authorities of country A, and therefore the
price was increased. This increase, however, was not accepted by the corporation-
tax authorities in country A. The company took this decision to court, but the court
decided that the decision of the customs authorities was not relevant to tax on
profit.

- In dealing with the customs authorities of various countries, multinationals may
adapt price setting to the customs regulations. This can, however, lead to different
transfer prices for different countries which in itself can be a source of criticism for
fiscal or other authorities.

- Minority shareholders and/or profit-sharing personnel may require a low transfer-
price level with the aim to maximize own income.

- In countries where, as a result of government interference, loans and other financial
means are hard to obtain, transfer prices might be changed to increase the cash
flow of the division in need. This in order to satisfy already existing local money
suppliers.

- Constraining foreign exchange control regulations may influence transfer prices as
sales and/or purchase of goods might be the single method allowed to transfer
money from one country to another.

- Governments usually try to capture the largest possible slice of the taxable cake. All
in all, the fiscal authorities tend to look critically at business practices which reduce
their portion of taxable revenue but show no interest in questioning the payments
that increase their revenues. Their attitude is asymmetrical which may result in
double taxation.

- In some industries, governments use data about transfer pricing to reduce, say, the
final prices to the consumers and may induce other countries to take similar action
(so called "domino effect") although the market circumstances may widely diverge.
In this process the least favored position for the industry tends to spread amongst
countries.

- Government interference on transfer prices sometimes imposes an inordinate amount
of reporting and red tape on the multinational. Data produced are occasionally used
by civil service bureaucrats without proper understanding of business mechanics.

The different approaches to transfer pricing from various types of authorities (for
example tax and customs) may cause conflicting requirements for the multinational.
As the first example given above showed, problems concerning these regulations may
be difficult, or nearly impossible, to resolve. In the requirements that are to be met
by the multinational, an important distinction can be made: some requirements are set
at the aggregate level and other at the disaggregate level, see also Sol [1985a].

30

Sec. 3.3 INTERNATIONAL TRANSFER PRICING

Corporation-tax authorities might judge a company on total company figures (aggregate
level). Custom authorities might judge prices for individual articles (disaggregate level).

The situation concerning transfer pricing is not only complex for a multinational.
Interpretation of the situation is also difficult for the authorities as "it is an essential
feature of the problem that it is always necessary to have regard for the particular
facts in each case", see OECD [1979, p. 18]. This might be the reason that most
disputes between authorities and multinationals concerning transfer prices are settled
before they reach court. This in itself can be regarded as a proof that transfer pricing
in practice is very difficult, see Verlage [1975, p. 194].

According to Plasschaert [1979, p. 34], it may well turn out that the most acceptable
system is one that minimizes conflicts with external groups, such as governments. Also
Verlage [1975, p. 194] underlines the importance of international transfer pricing. He
states that the situation around transfer pricing creates room for manoeuvering not only
for the multinational, but for fiscal authorities as well. Since in practice, the authorities
will try to use this room for their own benefit, it is necessary for the company to
analyze ways and means of defending its interest.

It will be clear that the problems around international transfer pricing are completely
different from the management-control problems as discussed in the previous chapter.
Transfer prices established for management-control purposes are intended to produce
internal goal congruence between the different parts of the company. International
transfer pricing aims at fitting the transfer-pricing policy within an external framework
of rules and constraints established by legislation and administration, see Quirin [1985,
pp. 132-133].

Over the last two decades, the awareness has increased that an international and well-
defined approach to international transfer pricing is needed. The "arm's length
principle" is one of the concepts which resulted from this approach. The arm's length
concept has originally been developed for fiscal purposes. It will now be discussed
briefly below.

The OECD committee on fiscal affairs [1979, p. 7] developed the arm's length concept
for fiscal purposes. The arm's length price is in their report defined as the price
"which would have been agreed upon between unrelated parties engaged in the same
or similar transactions under the same or similar conditions in the open market". Note
that the definition states: "which would have been". In other words, the concept is in
fact based upon a fiction. The Vereniging van Belasting Wetenschappen [1987, p. 65]
states that "it is more realistic ... to approach transfer-price problems from the point
of view of the multinational as a whole, in which each part has its proper business
function".

In order to assess whether prices are at arm's length or not, the following four
approaches have been established, see Verdoner [1988] and IBFD [1987]: r

31


Comparable uncontrolled price method
The comparable uncontrolled price method offers the most direct way of determining
an arm's length price. The transfer price is set by reference to comparable transactions
under the same or similar conditions between a buyer and a seller which are not
associated.

Resale-price method
There will be many cases where no useful evidence of uncontrolled transactions will
be available, because, for example, the goods which are supplied are so special to
the group that there is no open market for them. This is the case for patented drugs.
In such circumstances it will often be necessary, in order to establish an arm's length
price, to use the resale method. The resale (or sales-minus) method starts from the
fined selling price and subtracts the cost and profit mark-up of the last division
involved. The resale method is useful where it is applied to marketing operations of
finished or semi-finished products, like for a local marketing subsidiary of an
international pharmaceutical company.

Cost-plus method
In cases where neither the comparable uncontrolled price method, nor the resale
method are applicable, the cost-plus method can be used. The cost plus method starts
from the direct cost of providing the goods or services and adds whatever costs and
profit mark-up that are appropriate.

Other methods
The complexity of real-life business situations may put many conceptual and practical
difficulties to the application of the methods referred to above. A mixture of these
methods may sometimes therefore have to be used, sometimes in combination with
other methods. Another such method might be to look at the yield on capital involved
or to determine the contribution of the various units involved ("functional method").

Above, we limited ourselves to prices concerning the transfers of goods. Such transfer
prices, however, are only one of the instruments used for the international transfer of
funds within a company, see Krens [1979]. We explicitly consider international transfer
pricing only one aspect of the problem of international financing. As explained in the
previous chapter, pharmaceutical multinationals are in general highly centralized. Hence
various other means for transferring funds between parent and subsidiary exist. These
are now briefly described below, see Ammer and Ammer [1977].

Transfer prices
Transfer-price payments are the payments from the local subsidiary to the parent
company for goods bought from the parent company by the subsidiary. (As stated in
section 3.1, we limit ourselves to the prices of goods.) These payments are related to
the parent company's role of production center and supplier. (In section 3.5, a
distinction will be made between transfer prices and internal selling prices.)

32

Sec. 3.3 INTERNATIONAL TRANSFER PRICING

Royalty
Royalty payments are payments from the local company to the parent company in
exchange for the right to use proprietary trade marks, patents or other intangible
assets from the parent company. These payments are related to the parent company's
role of research center and patent holder.

Dividend/share capital
Dividend is the part of a local company's profit that is distributed among the
shareholders in proportion to their share of ownership. In our example, it is a payment
from the local company to the parent company. Share capital is also related to the
ownership of a local subsidiary. It is a payment from the parent company to the
subsidiary company. Payments of share capital and dividend are related to the parent
company's role of shareholder.

Current account
Another financial tie is the so called "current account". The current account is the
ongoing trading-debt position of the subsidiary company due to the purchase of goods.
It is possible to change payment terms for intracompany sales. By decreasing the
creditor's payment term from the parent company, debts have to be paid off earlier
and the creditors account will decrease. Hence the local company's liquidity decreases.
Increasing the payment term would have the opposite effect. Transfers due to changes
in the current account are related to the parent company's role of supplier.

Intracompany loan
A loan is a sum of money, borrowed at interest, for a period of time. The local
company can lend out to the parent company and vice versa. Payments are related to
the parent company's role of internal bank for the multinational group as a whole.

Cost transfer
A cost transfer is a payment from the parent company to the local company or vice
versa. It is based on a specific agreement between the two. An example is a
promotional allowance to compensate for the extra marketing effort of the local
company related to the introduction of a new product. Payment of allowances are
usually related to the parent company's role of management center. In exceptional
cases, the parent company may decide to compensate the legally existing loss of the
subsidiary company. So it is a payment from the parent company to the local
subsidiary. We classify these payments also as cost transfers. They are related to the
parent company's role of shareholder.

Like transfer prices, the size and conditions of the other financing instruments
described above, should be at arm's length, see IBFD [1984]. In the decision process
on local company financing, arm's length considerations play an important role.

The direction of the transfer of funds depends mainly upon the liquidity situation of
the local company. A liquidity surplus is defined as an excess of funds resulting from
operations. A liquidity shortage is defined as a shortage of funds resulting from

33

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