previous
next

CONSTRUCTING A “FAIR MARKET PRICE”.

88. In constructing a factory price by the methods just described, the manufacturing profit was determined without regard to the amount of profit left for the sales division. Whether there were a sales loss or a large selling profit, the manufacturing profit would remain the same. This is a one-sided, though very convenient, approach to the problem. It would be more logical and, at the same time, more difficult to consider both aspects of the problem simultaneously as an independent buyer and seller would do. The “willing buyer, willing seller” test is the one criterion which can be generally applied in judging the reasonableness of any intra-company price. This criterion unfortunately is so vague and indefinite that it almost begs the question. Some progress can be made, however, toward the establishment of objective standards which will indicate approximately the price which should result from a process of bargaining between a willing buyer and a willing seller who are well informed as to costs and prices. In other words, in the absence of a real market price, an attempt may be made to construct one which might reasonably apply.

89. The minimum price which a manufacturer can accept must be somewhat in excess of the total direct costs applicable to the commodity in question. These costs consist chiefly of direct material, direct labour, commissions on sales, etc. He would not care to sell unless he could recover at least a part of his overhead. On the other hand, the maximum price which a dealer can pay is determined by the probable selling price of the goods and the direct costs of handling and marketing them. The margin between the dealer’s purchase price and his probable selling price should be at least sufficient to cover his direct costs. The direct costs of the dealer include transportation charges, Customs duties, salesmen’s commissions, direct handling charges, etc. Sometimes the margin between the lowest price a manufacturer can accept and the highest price a dealer can pay is so narrow that a sale is impossible unless the manufacturer is willing to make a marked concession in favour of some particular territory or section of his market. Selling abroad at such prices is known as dumping and requires special consideration. The fact that a manufacturer may be willing to sell in a foreign market at more than his direct costs, but less than his full costs of production and distribution indicates the wide range which may exist in prices fixed by agreement between independent parties.

90. Under normal conditions, however, it may be assumed that the price will be fixed at a point which will permit both parties:

91. It may be assumed further that any profit in excess of the amount necessary to pay interest on the investments will be divided between the parties roughly in accordance with their relative contributions toward producing it. These relative contributions cannot be measured exactly, but if the manufacturer by extensive advertising in the territory or by other methods has created a goodwill for his product, he should be able to obtain the larger portion of the profit in excess of ordinary interest. The dealer, however, is likely to obtain this profit if he has done the advertising, and if the goodwill is in his name. With these assumptions as a basis, it is possible to work out a method of estimating or budgeting by which to construct a price which a willing buyer and a willing seller might be expected to reach under similar circumstances. Some form of budgeting is necessary because the factors which govern independent parties in price negotiations are probable future costs and selling prices, not past costs and prices.

92. Using the figures for actual past costs and prices as guides, an estimate can be prepared showing the probable volume of sales and probable selling prices at a given sales branch, or at all sales branches if a uniform inter-branch price is to be fixed. An estimate of the probable cost of materials may next be made and deducted from the proposed selling prices in order to ascertain the amount of probable revenue available for conversion cost, distribution cost and profit. Probable direct costs of conversion and probable direct branch expenses applicable to the goods in question may be ascertained, and reasonable allowances for factory overhead and branch overhead on the expected volume of business may be estimated. The deduction of these expenses leaves the expected profit on the goods under consideration.

93. Even if all of the estimates have been accurately and carefully made, there still remains the problem of dividing the expected profit. This profit may be divided by making an allowance for interest on branch investments and apportioning the remainder in accordance with the relative importance of the functions of manufacturing and selling in the particular business, or the whole profit may be apportioned by the method outlined in the following chapter. This method will not be presented in detail here, but, briefly, it involves the apportionment of profit, in this case expected profit, in the ratio of the conversion cost to the distribution cost applicable to the specific goods under consideration.

94. When the expected or budgeted profit has been thus apportioned, the inter-branch billing price can be readily determined. It will be equal to the estimated cost of materials, plus normal conversion cost, plus the budgeted manufacturing profit, plus a charge to cover export department expenses for merchandise handling and general supervision. When the finished product is shipped to the branch it will be charged at the price thus fixed, and this will constitute the first entry to be made on the formal books of account. All the work heretofore described has been analytical in nature. It has furnished a basis for budgeting and controlling the various activities of the business and for constructing a factory price. That price is now used and recorded on the books for the first time.

95. The advantage of a price fixed in this manner is that, within the limits of its own accuracy, it measures the relative efficiency of manufacturing and selling. If the manufacturing division operates with more than average efficiency, its actual profit will exceed the anticipated profit by the amount of the savings effected. It will, on the other hand, be penalised for excessive manufacturing costs. The sales division likewise will be rewarded for selling at higher prices or for reducing the cost of distribution, and it will be penalised for excessive distribution cost and for price concessions. Under actual operating conditions, however, the sales and factory prices and the expense budgets will have to be adjusted from time to time to compensate for market changes in the cost of materials or labour and for important changes in the competitive situation.

96. The procedure here outlined for constructing an inter-branch billing price can be used only by the management of a company; it is manifestly unavailable to tax officials because they could not possibly obtain the necessary data. They can, however, apply general tests which will indicate roughly whether the results obtained by the company’s methods are reasonable — that is, whether the prices used might reasonably apply as between a willing buyer and a willing seller. If the margin between the billed price to the branch and the selling price of the goods is so narrow as to eliminate the possibility of profit on a reasonable volume of business, or if this margin is markedly lower than that realised by independent dealers in similar lines, there is an indication of over-pricing. This becomes almost a certainty when the total profit on the goods is high. Note that the reference here is to gross profit on sales and not to net profits. A branch which has an adequate margin of gross profit may show a net operating loss due to a small volume of business or to extraordinary expenses, but such a loss should not be construed as an indication of over-pricing. Over-pricing is indicated only when the spread between the inter-company billing price and the ultimate selling price is so narrow as to preclude the possibility of adequate profit, even on a satisfactory volume of business. Very narrow profit margins for sales branches may be justified, however, when the total profit of the company on the goods handled is small or non-existent. In the final analysis a fair market price cannot be “constructed”. A detailed budget may provide the facts, but they must be interpreted and applied in accordance with the judgment of individuals familiar with conditions in the industry.

previous
next