Risk and Return

Taking risks is a necessary part of conducting business, with the level of return being the compensation for the degree of risk being taken. The specter of constant change or the acceptance that risks are a part of our everyday organizational life should not be taken as a reason for doing nothing about risk. At the very least, we need to identify every risk that our organization is exposed to whether they are market risks or exchangeable risks.

In the context of pricing goods and services, risk expresses itself in the variability, or potential variability, in the products or services we ­supply and the customers we supply to. Put more simply, our products may become unfashionable or too expensive, and our customers may change their business strategy or close up shop altogether leaving us with products that we can’t sell or debts that we can’t collect. When these circumstances change, a different set of risks is created, which may be either greater or less than the risk that has been eliminated. Our pricing activity needs to consider these possibilities when deciding on the return required at either a product or a customer level. Where the perceived degree of risk, whether it be product or customer related, is higher, selling prices need to command a premium over the prices charged for those products or services, or to those customers, seen to be less of a risk.

Furthermore, when considering the returns required from a particular selling activity, an additional aspect to consider is the extent of your investment in both the product or service and the customer. This will usually comprise investment in long-lived resources, whether for the organization as a whole or specifically for a product, service, or customer, as well as supplies, work-in-process, and monies due from the customer. The funding for this investment comes from our investors, either in the form of equity or debt, who require compensation for investing their funds with us. For every organization, the extent of this compensation reflects the average of the cost of debt and the cost of equity weighted in their market-value proportions. As such, it represents the rate of return we must earn on the resources employed in our organization to meet the expectations of our investors.

There is little doubt that the level of investment varies between products and services as well as between customers and so the prices we charge should reflect the financing cost of the relevant level of investment. In so doing, if the prices we establish are too high, then we need to look for ways to reduce the investment for we cannot accept lower returns. To do so would not allow us to compensate our investors appropriately, which may probably lead them to withdraw their funding with the potential to ultimately force us out of business.

Moving from External to Internal Pricing

Unreasonably, when it comes to internal pricing, many organizations continue to approach their pricing decisions in terms of adding something on to the cost. Cost in this context is almost always the total cost, which in many cases is an imprecise and significantly inaccurate value on which to base a selling-price decision. In reality, setting selling prices is concerned with establishing the best price that a prospective end customer will pay for our product or service as well as knowing the lowest price that is acceptable.

By comparing the selling price we think may be achieved with our cost estimate, we are in a position to understand whether making the sale is likely to give us the return we require on our investment in the business. Where we lack accurate or complete market price information for our product or service, our own costs will be helpful in determining a selling price as long as we believe that these costs are typical and competitive. In practice, most organizations approach the determination of selling prices through a combination of market research and costing.

On occasions, the market selling price will be lower than the projected selling price derived from the cost of our product or service plus the margin necessary to provide for an adequate return on our investment. In these situations, we shall need to decide whether to:

• accept a lower price, margin, and return on investment;

• explore ways of reducing our costs;

• explore ways to differentiate our product or service, which is in effect changing our market positioning.

If we decide to explore ways of reducing our costs, we need to look for ways of increasing efficiency in purchasing, production, or distribution. On the other hand, if we are happy that our cost information reflects ­reality and that our operational processes are highly efficient, then we have to accept that our competitors, who are selling at lower prices, are willing to accept a lower margin and probably a lower return on their investment. In this situation, we need to reflect on our strategy and position in the market.

I have tried to make it clear that price decisions, both internal and external, are a combination of market research, competitive analysis, and cost information. In determining selling prices, we are attempting to achieve our strategic objectives and return on investment through maximizing our market share, taking into consideration such factors as our own resources and capabilities, competitive prices, market demand, strategies available, as well as social and legal issues. We supplement these factors by continually monitoring our sales volume, sales mix, and actual performance and feeding the information collected back into our pricing model. Setting the right price for our products or services is undoubtedly one of the most challenging activities in any organization and even more so when we are required to consider two or more related organizations involved in the delivery of the final product to our end customer.

It is essential to set prices that will simultaneously make us competitive within our own market and allow us to grow revenue. Achieving this delicate balance means knowing not only our costs, but also the state of our industry and the overall economy. Most importantly, it means knowing our industry and our business in considerable depth, as well as our end customers and what it takes to convince them to buy.

All of these factors underlie the organizational and behavioral issues that need to be taken into consideration in any discussion that takes place inside an organization in relation to transfer pricing. To meet their organization’s overall objective of maximizing shareholder wealth, managers need to be ever vigilant for ways of improving efficiency and effectiveness, and hence profitability, usually through cost reduction or business change programs. There is no question that in multiproduct, multi-process organizations, a divisionalized structure, where each division is of a much more manageable size and is regarded as a profit center, is more advantageous in these circumstances.

Nevertheless, it is inevitable that all divisions are not totally independent and this creates particular difficulties in measuring divisional performance and in avoiding actions by divisional managers that are detrimental to the organization as a whole. The alternative, which requires some degree of interference in divisional management’s affairs, inevitably waters down the benefits of this form of organizational structure and undermines managerial independence. Yet, to be fair, each of the divisions in such a structure cannot be totally independent for it is part of the organization as a whole.

Compromise between divisional independence and corporate coordination is absolutely essential to prevent suboptimal behavior by divisional managers who often circumvent the organizational ethos in search of better results for their division, and greater rewards for themselves, to the detriment of overall organizational performance. Nowhere is this more evident than in the thorny issue of transfer pricing, which has implications for the organization as a whole at all levels from strategic planning through to supply chain management.