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THE INDEPENDENT DEALER PRICE METHOD.

57. If for any reason the commission basis is not applicable or desirable in computing the income of a branch, a so-called independent dealer price or factory price may be used. The price to an independent dealer for manufactured goods frequently is arrived at by a percentage discount from the “list price” at which the goods are to be sold to customers. This price, under normal conditions, falls between the cost of production on the one hand and the final selling price to customers on the other, and thereby effects a division of profit between the manufacturing division and the sales branch which disposes of the goods. The use of this method of accounting for inter-branch transfers of goods implies that each branch is to be viewed as a separate business unit and treated as nearly as possible like an independent concern. This of course entails either allocating to this branch the expenses and losses incident to the transfer, presumptively, of ownership of the goods to the sales branch which can be facilitated by allotting to it an adequate capital.1

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58. Between independent concerns, prices are determined by bargaining, a procedure seldom available in inter-branch pricing. There are, however, a few concerns which base the remuneration of branch managers directly or indirectly on the rate of return earned on the branch investment. Where this is done, branch managers are likely to watch billing prices very closely, and their interest in obtaining favourable prices on goods received from or shipped to other branches of the same company to some extent introduces an element of independent bargaining. There are two objections to this arrangement. In the first place, it may cause dissension and competition between managers whose co-operation is essential, and, in the second place, the managers, though they may influence, cannot control inter-branch prices. The central management has the final vote in deciding what the prices shall be, and its vote may be cast with ends in view other than the equitable division of profit between branches. It is therefore apparent that, since inter-branch transactions can never be made at arm’s length, no process of intra-mural bargaining can be depended upon to fix inter-branch prices correctly and without bias.

59. In the absence of direct bargaining, the next step is to seek an independent criterion established by the bargaining of others. If the commodity in question has a world market and quoted market prices are available at all stages in the process of production and distribution, these market prices offer the best possible basis for inter-branch pricing. They are broadly based and can seldom be controlled by any single concern in its own interest. Their use gives a true picture of the real economic value of a branch. Suppose, for example, that a manufacturing branch which bills its entire production to other branches at current market prices consistently shows a loss. That does not indicate an error in pricing; it simply indicates that the manufacturing branch is not earning its keep, that the concern can buy more cheaply than it can manufacture the commodity. This, of course, is based on the assumption that qualities are comparable and that the quoted prices apply to the quantities which the concern in question actually handles. If the grading of the commodity is not standardised, or if the quoted prices are based on small volume, the method of billing at the market price becomes less reliable and may even cause a distortion of results. Market prices, however, even though they may be far from perfect, have this tremendous advantage — they are not influenced by considerations of tax liability. They should be used whenever possible.

60. For the great variety of patented or branded articles market prices are, of course, unavailable. Here it is sometimes possible to use a so-called independent dealer price or factory price. A manufacturing concern may distribute its product partly through its own branches and partly through independent dealers. Where this is done, satisfactory results may, under certain conditions, be obtained if the branches are charged the same price as the dealers. The prices so determined are really semi-independent; they are established by a process of bargaining between the company and the independent dealers, and sometimes the one and sometimes the other side will have the greater bargaining power. The prices, moreover, to different dealers may not be the same. Furthermore, although a company may distribute only a small proportion of its total production through independent channels, the use of the independent dealer price for inter-branch invoicing implies that the entire product of the company could be sold to independents at that price, an assumption contrary to fact in many cases. If these limitations are kept in mind, the price charged to independent dealers may furnish a good criterion by which to judge the reasonableness of inter-branch prices. The independent dealer price will be satisfactory as a basis for invoicing goods to branches, if a substantial part of the company’s product is regularly distributed through dealers who are charged a uniform price and who operate under conditions similar to those at the branches with respect to volume of business and character and size of the territory served. Where these ideal conditions do not exist, some allowance for differences will have to be made in fixing inter-branch prices. Where the differences are marked, the method cannot be used directly, but it will serve as a rough check on the reasonableness of prices charged to branches.

61. If neither “market prices” nor representative prices charged to independent dealers are available, inter-branch billing prices may be constructed from internal data, or fixed according to informed judgment of a company’s own executives. Methods by which a factory price may be constructed will be considered in the following chapter, but neither a constructed price nor a price fixed by company executives can be regarded as independent. Independent prices must be obtained on the open market or by reference to actual contracts with dealers operating on the same scale as the branch in question. An independent factory price established on this basis meets two of the three objectives mentioned in the preceding chapter. It allocates to each branch the profit which it would earn if it were operating as an independent entity, and it obviates the need for extensive enquiry into the world business of an enterprise. It does not, however, safeguard the manufacturing establishment from taxation on an unrealised profit in respect to unsold goods. In order to meet this second test of reasonableness it is necessary to provide a method of adjusting the accounts of the manufacturing division for the element of unrealised profit in branch inventories. The necessity for this adjustment and the method of making it can be most easily shown by an illustration.

UNREALISED PROFITS IN BRANCH INVENTORIES.

62. A manufacturing plant in one country, it will be assumed, ships merchandise which cost $75,000 to a sales branch in another. The merchandise, however, is billed at $100,000, which is $25,000 in excess of cost. As a result, the manufacturing plant shows a book profit of $25,000 not yet actually realised by sales to outside concerns. The company as a whole obviously realises no profit on the inter-branch transfer itself, but it does realise a profit when the goods are sold to an outside purchaser. If this sale occurs in the same fiscal period as the inter-branch transfer, the taking up of a manufacturing profit a short time before its actual realisation by bona-fide sales to outside parties causes no accounting difficulties. Suppose, however, that 40 per cent of the goods remain unsold at the end of the period and appear in the inventory of the sales branch at a value of $40,000. Since these unsold goods cost only $30,000 (40 per cent of $75,000), it is apparent that the branch inventory figures include $10,000, of manufacturing profit, which has not yet been actually realised. In preparing consolidated financial statements for the company and all its branches, this unrealised profit would be eliminated; that is, the carrying value of the unsold goods would be reduced to cost, $30,000. From the point of view of the company as a whole, this adjustment is necessary, since it would be grossly improper to treat as profit a mere mark-up incidental to an inter-branch transfer of goods.

63. An adjustment of this kind, however, is inconsistent with the idea that branches are separate business units, unless it be assumed that the original transfer was a consignment rather than a sale. If the manufacturing branch had sold the goods to an independent purchaser there would have been no adjustment for unrealised profit, even though the goods remained unsold on the dealer’s (buyer’s) shelves. Consistency would seem to require that no such adjustment should be made with respect to goods held by a branch operated on a trading basis, but, since the taxing of manufacturing profits which have not been actually realised is unduly severe, tax authorities may properly permit the home office on its return to eliminate the unrealised profit. This is equivalent in effect to placing the branch on a consignment basis1 and is therefore not at variance with accepted business practice. In this connection, it should be noted that, on sales made to a subsidiary company or to an independent dealer, losses may be shifted back to the manufacturing company in the form of bad debts. If a dealer is compelled to sell goods at a loss, he may be unable to pay for them, and all or part of the loss may fall on the manufacturer. Since a concern could hardly be allowed a deduction for losses on bad debts for merchandise transferred to its own branches, it should be allowed to eliminate unrealised profits from its taxable income.

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64. There are several methods by which this elimination can be made, but all lead to practically the same result. At the time of the original transfer, it may be assumed that the manufacturing branch (at the home office) made an entry debiting branch current account and crediting sales to branches (or shipments to branches) for $100,000, and that it also made an entry debiting cost of sales to branches and crediting finished goods for $75,000, the cost of goods transferred. At the end of the year the following entry could be made to defer the unrealised profit in the 40 per cent of the goods which remain unsold.

       
Sales to branches  40,000 
Cost of sales to branches  30,000 
Reserve for unrealised profit in branch inventories  10,000 

The reserve account indicates that the branch current account is overvalued to the extent of the unrealised manufacturing profit included in the branch inventory.

65. At the beginning of the following year, the above entry would be reversed as shown below.

       
Reserve for unrealised profit in branch inventories  10,000 
Cost of sales to branches  30,000 
Sales to branches  40,000 

The effect of these entries obviously is to defer the manufacturing profit to the year in which the goods are sold outside the organisation. This should not ordinarily have much effect on the tax finally paid, unless the tax rate is changed, but it would defer the tax to the year in which the profit was actually realised by the company.

66. Another question arises with respect to this unrealised profit. If the goods are finally sold at a loss, should the profit included in the original billing price be eliminated permanently from the income of the manufacturing branch? It is, of course, true that a manufacturer would ordinarily assume no part of an independent dealer’s loss and that, by analogy, the manufacturing division of an enterprise should make no allowance for losses suffered by a so-called independent sales branch. There is force, however, in the argument that a concern should not be taxed on a profit which was not actually realised when the goods were sold to outside parties. In the illustration just given, if the unsold goods valued at $40,000 in the branch inventory were later sold for $36,000, it would seem more logical to assume that there was a realised manufacturing profit of $6,000 and no sales profit than it would be to assume that there was a manufacturing profit of $10,000 and a sales loss of $4,000.

67. If this view is accepted, the necessary adjustments in the accounts can be made quite easily. When the goods are actually sold at less than the billed price, or when it becomes apparent that they will have to be sold at a sacrifice, the sales branch could request an allowance sufficient to reduce the intra-company billing price to the amount which it had obtained or would be able to obtain from customers. At the home office, this allowance would be recorded as a debit to sales to branches and as a credit to Branch X current account for $4,000. The branch, at the same time, would make an entry debiting the home office current account for $4,000 and crediting an account which might be called purchases or preferably merchandise from home office. For the sake of definiteness, it is recommended that allowances of this kind be limited to the difference between the actual selling price of the branch and the original billing price, or to the amount of manufacturing profit included in the goods, whichever is smaller. By this method, the more serious injustices may be corrected without necessitating a complete redetermination of inter-branch billing prices.

INTER-BRANCH EXPENSE CHARGES.

68. If a branch is sufficiently autonomous to be treated for accounting purposes as a separate business unit, most of its expenses are likely to be covered by direct payments made by the branch itself. It is inevitable, however, that there will be some inter-branch expense charges and under some circumstances these charges may constitute a substantial part of the entire cost of operating a branch. Inter-branch charges fall into two general classes: (1) direct charges for supplies furnished or specific services rendered, and (2) apportioned charges representing the share of a given branch in those general expenses which cannot be specifically assigned. When direct charges are substantial in amount, the problem of pricing becomes important. Theoretically, an autonomous branch should be charged at current market prices for all supplies received, but this in many instances is equivalent to cost. If a home office merely buys supplies in large quantities and distributes them to the different branches as needed, the practical method of procedure would be to charge each branch for the actual cost plus handling charges. It might be possible to use a slightly higher price in order to give the home office the full benefit of the saving effected by purchasing in large quantities, but ordinarily such a refinement in making charges for purchased supplies seems unnecessary.

69. A different situation exists, however, in connection with supplies or materials manufactured by the enterprise itself for the use of its domestic and foreign branches. A large industrial concern might, for example, construct and operate a factory to supply boxes or cartons for the use of sales branches in packing and shipping the product. The box factory, if all accounts are placed on an independent basis, would be viewed as a separate undertaking to be operated at a profit. The boxes which it produces should, therefore, be billed to other branches of the same enterprise at market prices. The same rule would apply to any other independently operated service department or branch. No branch, however, should be compelled to pay more for supplies or services obtained from other branches of the company than it would have to pay if the same items were secured from independent sources.

70. Charges for direct services rendered should follow the same rules which govern the charging of supplies. The pricing of services is more difficult because recognised market or customary prices are seldom available, and the determination of the cost of the given service is usually difficult. Cost would seem to be the most reasonable basis for ordinary inter-branch service charges, but when the rendering of the service is regular and substantial enough to be placed on a commercial basis, it should be charged to branches at a price which will assign a commercial profit to the service function. It is conceivable, for example, that a company might operate an electric power plant in one country and furnish power to another branch of the company across an international boundary. Under such circumstances, it would be desirable to charge the branch for power at the rate which it would pay to a public utility for the same service. All services, however, which are not thus operated on a commercial basis should be charged to branches as nearly as possible at cost.

GENERAL OVERHEAD EXPENSE.

71. Quite a different problem arises in connection with expenses which are incurred for the benefit of the enterprise as a whole. It is apparent that a branch, even though it operates as a separate business unit, must bear its share of the general overhead of the concern and its share of the costs of branch supervision incurred by the home office. The problem, however, is to make sure that a sales branch does not bear a double charge for these items. It is a fundamental concept of separate accounting that inter-branch charges for merchandise are to be priced at the market, or, in the absence of quoted market prices, at a price which an independent dealer would pay under similar conditions. Now what do such prices include? Normally, if a concern is to survive and prosper, the selling price of its product must cover all production costs, selling expenses, and general administrative expenses, and leave a reasonable margin of profit. If the same price is applied to a branch it would seem to include the same elements, but this is not quite true. When goods are distributed through independent dealers, the manufacturing concern must first make sales to dealers, and the dealers must then make sales to ultimate consumers or even to other dealers. In this scheme, there are at least two points at which sales resistance must be overcome, and this requires two types or divisions of selling expense — namely, the selling expense necessary to effect the distribution of goods to dealers, and the selling expense which dealers must pay in distributing the goods to customers. This situation is changed when a concern elects to distribute through its own branches. The sales effort and selling expense required for making sales to dealers are eliminated and in their place we find the costs of branch supervision.

72. No statistical data are available to support a conclusion that the costs of branch supervision are less than the costs of effecting sales to dealers, but it is obvious that in the opinion of the management of companies which distribute through their own branches, this method has some advantages over the method of distribution through independent dealers. It may be assumed that a part of this advantage is due to the fact that the costs of branch supervision are less than the selling expense which otherwise would be necessary. If this assumption is true, the independent factory price would obviously be sufficient to cover all the costs of branch supervision. It would seem, therefore, to be unnecessary to make an apportionment of such costs to the different sales branches.

73. The question whether an apportioned charge to cover the costs of branch supervision should be made in addition to the charging of an independent factory price for merchandise transferred is one of extreme difficulty. It is clear that the independent price includes at least all overhead expense which relates directly or indirectly to factory operation. It is likewise clear that this price must be presumed to include an allowance to cover the cost which would be necessary in effecting sales to independent dealers. When the costs of branch supervision are substituted for these selling costs, a net saving may or may not result; in any event, no accounting methods are available by which the amount of a saving of this kind can be determined. The fact is that the interrelationships between costs and prices at this point are so complex as to baffle any attempt at complete analysis. This much, however, can be said with safety. When a sales branch obtains all or substantially all of its stock in trade from a manufacturing branch of the same company and pays the same prices that an independent concern would pay, the presumption is that the billing price includes the branch’s fair share of the general overhead of the company and the costs of branch supervision. This is a presumption only, and it must be recognised that there may be circumstances under which a charge against a so-called independent sales branch for managerial services would be entirely proper. The point here insisted upon is simply that a branch should not be charged with both the market price of merchandise and the full share of the general company overhead which would be properly chargeable against a branch which was billed at cost for merchandise from the home office. The management charge against a branch, if allowed at all, must not be large enough to cause duplication of this kind.

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