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Transferpricingintheautomotiveindustry*Productioncapacitymanagementandtransferpricingeconomics01Foryearsthemantraofautomotiveproductionhasbeentosupplycustomerswith“highquality,low-cost,innovativeproducts.”Asemergingmarketshavedevelopedintohighqualityproducersinadditiontolow-costcenters,automotiveOEMshavemovedproductionintotheseareasinsearchofmorecustomersandgreatercostsavings;suppliershavenaturallyfollowed.WhileOEMshaveregularlyincreasedsalesvolumesforvehiclesworldwide,globalproductioncapacitygrowthhascontinuedtooutpacecustomerdemand.Inrecentyearstheutilizationofthatglobalcapacityhasbecomethefocusofattention.In2005therewere6majorplantclosingsaroundtheworld,but18newplantscameonlineduringthesameperiod.Thistrendisexpectedtocontinueoverthecomingyears1[seechart].ProductionCapacityManagement(PCM)isclearlyrequiredtoensurethatthecostsofproductionenhancetheaffordabilityofproducts.PCMoccurswheneveranewplantopens,oranexistingplantexpands,contractsorcloses.AndwhilePCMbeginsinoperationsorstrategydepartments,financeorganizationsprobablyhavethemosttoofferwhenevaluatingthebenefitsofPCM.Applyingtheprinciplesoftransferpricingeconomics,financeorganizationscanenhancethesuccessofproductioncapacitymanagementmovementsinthefollowingways:•Evaluatingandestablishingoperationalinfrastructure;•Developing“newplant”metrics;and•Taxconsiderationsandothercosts.Transferpricingeconomicsisapracticalcombinationofmicro-andmacroeconomics.Properlyapplied,itlaysouttheentirevaluechainofactivitiesofacorporationonalocationbylocationbasis,inordertoassessthemostequitablepossiblearrangementsbetweendisparateentitieswithinacorporation.Thenitcomparesthecircumstancesofeachentityandassignstargetprofitstoeachlocationbasedonitsparticularactivities,assets,andrisks.-1500-1000-5000500100015002000-20-10010203040-1500-1000-5000500100015002000CapacityaddedGlobalplantopenings&closures2006–2010Globalplantopenings&closures2001–2005Capacity(in000s)NumberofplantsCapacity(in000s)NumberofplantsPlantsaddedCapacitycutPlantscut-30-20-1010203040-3001Source—PwCAutomotiveInstitute,AUTOFACTS2006Q3forecastreleaseUsingtransferpricingeconomicsrevealshiddenopportunities.0203OperationalInfrastructureKnowinglevelsandlocationsofprofits,cash,andtaxesisofparamountimportancetoanyPCMstrategy.Usingtransferpricingeconomicstomapallthetransactionsinwhichthenewplantwillparticipate,withsuppliersandcustomersaswellaswithrelatedparties,revealshiddenopportunities.Mostlikely,thesourcematerialandfinishedproducttransactionshavebeenidentifiedandestimated,butwhataboutservicesandintangiblesthenewlocationwillrelyupon?Forinstance,willthenewlocationperformitsownvendoridentification,qualification,developmentandpurchasingactivities?Doesithavetheappropriateresourcestocompletetheseactivities?Willestablishedproceduresbetransferredtothenewplantbyanexistinglocation?Willestablishedsuppliersbeshiftedtothenewlocation?Ifthisactivitywillbeperformedbysomeoneelse,howmucharetheseservicesworthtothenewplant?Properplacementofthesetypesofactivities,socriticaltosuccessfuloperationsatthenewplant,cangeneratesignificantsavingsfortheplantorprovidesignificantincometothepartythatactuallyperformstheactivities.Somecompanieshaveestimatedthatbybettermanagingtheirsourcingoperations,hundredsofmillionsofdollarscanbesaved.Attheextreme,onemajorglobalautomakerhasrecentlytargeted$1billioninnetmaterialcostssavings.WhetherthesesavingswillinuretoasinglelocationortoseveralisastrategicconsiderationunderPCMthattransferpricingeconomicscanhelpanswer.Othercriticalactivitiesmustalsobesimilarlyconsideredsuchas:productionplanning;researchanddevelopment;qualitycontrolprocessesandprocedures;in-plantcustomerrepresentation,andlogistics.Transferpricingeconomicsnotonlyestablishesanarm’slengthamountofprofitsavailabletothenewoperation,butitalsouncoversoptionswithinexistingglobaloperationalandtaxparametersthatmaximizesthevalueofthemanufacturingaswellasthesourcingactivities.Thearm’slengthprinciplereferstothepricesontransactionsbetweenrelatedcompanies.Thesemustbesetinaccordancewiththeeconomicconditionsbetweenindependentcompetitivefirmsinthesameorsimilarindustries,withoutbeinginfluencedbytherelationshipsbetweentherelatedcompanies.Howtomaximizetransferpricingeconomicsinoperationalinfrastructure:•Mapoutlocationsofactivities•Determineprofitsassociatedwiththeactivities,assets,andrisksoflocations•Determinewherecashisrequired•Moveactivities,assets,andrisksbeforeoperationsbeginCasestudy:WhenTier1suppliersbegantooperateinMexico,theysoldtotheirnewcustomersatapricethatwassignificantlylessthanthepre-Mexicoprice.Fortunatelyforsuppliers,thelaborcostdifferentialwasgreaterthanthepricedifferential.TheendresultwasthatmanyMexicanoperationsbegantoaccrueprofitsabovewhattheirmanufacturingactivitiesactuallydeserved.CashbecametrappedinMexico,forcingcompaniestobecomeunnecessarilycreativeiftheywanteduseofthefunds.KnowingwhothecustomersareandwhattheoperationsoftheMexicanplantaretobe,allowedsomeTier1supplierstosettheappropriateprofitsforMexicoandensuredthatthevalueforservicesandmarketingintangibl