Transfer Pricing, Ethics and Governance Case Summary
Transfer Pricing, Ethics and Governance Case Summary
Gera International is a well established international brand of beer that is ranked amongst the top three brands of beer in the world. With transportation prices rising, Gera International decided to purchase a plant in Antigua in 2005 and they renamed the subsidiary, Caribbean Brewers, Inc. (CBI). In 2008, the production facilities of CBI were expanded and their productive capacity doubled. Furthermore, we are then introduced to Jason Joseph a production manager who is unhappy and distressed because along with the production doubling, he lost ownership in the company, bonuses, and annual dividends. JJ comes to us (the financial advisor to the CFO) and informs us that although the process of brewing their beer has not changed, the costs measurement system that is in place is unfair to him and causing him to want to quit. It is unfair to JJ because CBI uses a percentage of sale system, and this takes away from the control of the production employee because he has no control over sales.
Nevertheless, JJ explains how the quality of the beer is causing him to lose profit on shipping fees. Gera has complained about the quality of beer exported to other Caribbean countries and they refuse to pay the shipping terms. JJ is positive that the consistency of the beer he exports is accurate and that the quality excuse is just a reason for Gera to get away with not paying the fee. We have also been provided with a letter from the Inland Revenue Department stating that we will have our tax filings reviewed for the years ending – December 31, 2008, 2009, and 2010. In the following report we will address the rising production costs, the performance measurement system, and report on any vulnerability and risks associated with our upcoming tax audit.
Rising Costs of Production
JJ focused on production cost per case prior to the expansion. Now, Gera International holds employees accountable for production cost as a percentage of sales, which seems to be misrepresenting the efficiency of production. From 2007 to 2010, total production costs increased from approximately $27M to $56M. In addition, sales have increased from about $66M to $98.5M. This shows an increase in production costs by 107% while sales have only increased by 49%. It appears that costs have been growing at a greater rate than sales; however, the majority of the rising costs are from the exported Gera Beer where the $8 deposits cannot be collected. Gera’s domestic beer sells for $50 per case of 24. Their exported beer is invoiced for $25 per case. With the domestic cases, Caribbean Brewers collects a bottle deposit of $8 per case, but no deposit is invoiced to Gera Caribbean for exported Gera beer. Gera Caribbean invoices the islands of the eastern Caribbean for $50 per case plus an $8 per case deposit for bottles. Therefore, as long as bottle costs continue to be presented net of deposits, costs as a percentage of sales should be expected to rise.
If CBI were to present their production costs in a format that showed bottle costs and deposit revenues separately, the format using percentage of sales would not appear to be so inflated. In addition, if bottle costs were shown separately, a more efficient representation of production costs would be seen. Also, the majority of all other costs as percentage of sales have been rising since the expansion in 2008. The difference in prices for domestic ($50/case) and exported ($25/case) has impacted the percentage of sales, as well. The costs as a percentage of sales increased as CBI began to sell Gera beer at $25/case because the cost percentage was greater than the percentage of the selling price.
It is impossible to maintain costs as a percentage of sales when selling at a discounted price. CBI is still generating profit per case on the exported products sold. This proves that percentage of sales in not an accurate assessment. If CBI’s internal statements included total bottle costs they would show the production has actually decreased from a cost per case from 2007 to 2010. Representing costs as a percentage of sales is not the best way to judge efficiency since it can ignore variables such as bottle deposits and discounted rates, which would show problems in production when in fact there are not any. Therefore, JJ’s statement on production remains truthful when he said that CBI has been operating as efficiently, if not more, in the past.
Performance Measurement System for Production Personnel with Respect to Both Cost and Quality Control
JJ has complained on behalf of the performance measurement system because currently his bonus is based off of production cost being less than 43 percent of sales. JJ believes that the production facility is operating as efficiently as, if not better, than it has before the expansion. Due to this performance measurement JJ’s ownership when from 25 percent to 8 percent and he is losing bonuses and annual dividends.
As we analyze Figure 2, we have determined from a costs perspective that basing production manager’s bonuses off of a percentage of sales is unethical because he is not being based off of his “performance.” For starters, in 2008, CBI expanded and began producing Gera beer, which unlike other exported beer, does not collect an eight dollar deposit fee. Next, from 2008 to 2009, CBI was hit with a $6,128,000 bottling fee due to the increase of production units. Our group then looked at their depreciation costs because it increased $3,240,000 from 2008 to 2009 due to the plant’s expansion. JJ had no control of capacity doubling nor was he involved in an increased depreciation expense, so we believe his bonus should not be based off of it. Total production costs increased $20,344,920; alone the bottle variable cost and the depreciation fixed cost total increase was $9,368,000, resulting in nearly 50% of total production costs increase.
If we had removed the increase of the two costs, the 2009 total production costs would have been $37,842,320 and this would have only been a 42.96% of sales. JJ would have still been a happy fellow because he would have met his threshold. From another perspective, fixed costs in general are typically not something that a production manager can control; however, CBI still includes these costs when considering the production manager’s bonuses. The production manager also cannot control how many cases are sold and how much the beer is sold for so by comparing the costs to sales would cause JJ to lose bonuses if sales were low. If we use the chart based off of gross margin above and only include variable costs, this performance measurement system would be a better depiction of how JJ and his production team is performing; however, by basing things off of items they cannot control this creates an environment where no one is motivated because their sole performance is not evaluated.
Next, we will evaluate the performance measurement system for production personnel with respect to quality control. Gera International is refusing to pay shipping because they believe that CBI is shipping poor quality beer to their facilities. Nevertheless, JJ has been a production manager for decades and he is one of their master brewers and has informed us that Gera is “making false allegations about the quality to justify not paying for some of the shipments.” JJ assures us that the process has not changed and that he has been more consistent than ever. JJ also mentioned that his local customers would have complained had the quality of the beer decreased. We recommend that CBI and Gera come up with a quality report that they can agree upon inspection is the “Gera International Standard.”
Vulnerability and Risks Associated with the Upcoming Tax Audit
After preparing for the tax audit we found that we may be subject to tax penalties with the IRD. The following figure depicts an Antiguan tax law:
This tax anti-avoidance section outlines that any resident corporation that conducts business with a non resident business and the business conducted
causes the resident business to produce a lower profit that gives them the tax holiday, could be subject to penalty for evading taxes.
After reviewing Figure 4, we have discovered that all export sales of Gera beer are made to Gera Caribbean, a wholly-owned subsidiary of Gera International, which is located in a tax free jurisdiction. The Corporate Transaction Flow Chart depicts that CBI invoices Gera Caribbean, but deliver directly to the customers of other islands. CBI domestically sales a case of Gera beer for $50, but the exported Gera beer is invoiced to Gera Caribbean for $25 and then Gera Caribbean invoices the other Islands for $50 plus the $8 case deposit. To the auditor, this looks as if Gera International is attempting to evade taxes by selling the Gera beer for a profit from the tax free country in Bermuda, when in fact they are distributing/selling the beer to the Other Islands straight from Antigua (where they would be subject to taxes). We have also discovered that CBI may be trying to escape the tax liability by not including the bottle deposits for exported Gera beer.
We have found that “CBI collects a returnable bottle deposit of $8 per case on domestic sales and exported Tigua beer. Contrary to this normal business practice, no deposit is invoiced to Gera Caribbean for exported Gera beer.” By not invoicing the $8 per case on exported Gera beer, CBI could be looked at as trying to apply it towards the non-taxable Tiguan beer to evade taxes. How Concerns Over Transfer Pricing Will Affect Minority Shareholders Our concerns regarding transfer pricing will negatively affect minority shareholders. For example, JJ has seen not only his share amount decrease, but also his dividends ceased as a result of the purchase of majority shares from Gera. This absolutely hurt minority shareholders in his position, as it essentially diverts the profits into the overall Gera Product, as opposed to his previous stake in just CBI beer.
In addition, potentially the most important factor comes from the bottle refunds. Whereas previously, the bottles were not factored in their cost, now they are now being expensed to the factory and hurting the bottom line of CBI. How the Board May React to Adverse Consequences to Minority Shareholders In a perfect world, we would like to imagine that all shareholders are unified in the objective growth of the company. Unfortunately, this is not always the case, such as here. In this case, the transfer of the beer between islands and the new handling of bottle deposits is perfectly acceptable to the Board of Directors and thus the majority, but it absolutely affects the lesser shareholders, such as JJ, in a much more tangible way.
The Gera acquisition is bad for minority shareholders such as JJ, and Gera needs to act in such ways as to keep these employees satisfied, or risk losing them to competitors. It might not be as strong of a move as bringing in dividends or anything to that degree, but employees like JJ, who were around before Gera, need to be incentivized in similar means to how CBI operated, else Gera will lose them.