Transfer pricing within hospitals
An investigation into how the costs of the operating rooms of the
Martini Hospital could be internally transferred to the users
Arjen Pen
Groningen, June 2010 University of Groningen
Transfer pricing within hospitals
An investigation into how the costs of the operating rooms of the
Martini Hospital could be internally transferred to the users
Master thesis Arjen Pen
University of Groningen
Faculty of Economics and Business
Master of Science Business Administration Organization and Management control
Organization: Martini Hospital Groningen Groningen, June 2010
Student number: s1711121 Total European Credits: 20 EC
First instructor University of Groningen: Dr. P.E. Kamminga Second instructor University of Groningen: Dr. B. Crom Instructors Martini Hospital:
List of important abbreviations
DBCIn Dutch Diagnose Behandel Combinatie which stands for ‘The sum of activities performed by the
hospital and the specialist, as a result of the question for care with which the patient consults the specialist in the hospital. The activities contain medical and medical supporting activities, as well as clinical and outpatient activities’ (Crom, 2005)
RVE
In Dutch Resultaat Verantwoordelijke Eenheid which stands for the 29 divisions which are in the
decentralized structure of the Martini Hospital responsible for their own revenues and costs.
OLVG
Onze Lieve Vrouwen Gasthuis which stands for a hospital in Amsterdam.
KNO
Ear, throat and nose care ( In Dutch Keel Neus Oor)
CSA
Central Sterile Department ( In Dutch: Centrale Sterilisatie Afdeling) which is a unit of the RVE operating rooms which is responsible for cleaning, disinfecting and sterilizing reusable instruments.
PBU
Outpatient Treatment Unit ( In Dutch: Poliklinische Behandel Unit) which is a unit of the RVE operating rooms which executes surgeries under local anaesthesia.
SCT
Preface
Dear reader,You are at the starting point of reading my master thesis. Personally, writing the master thesis was the toughest challenge of the study Business Administration at the University of Groningen. However, during the writing of my master thesis and the period I stayed at the Martini Hospital I obtained several new practical insights which will help me in the coming period by looking for a job.
There are many people I would like to thank for their support during writing my master thesis. Firstly, I would like to thank the organization the Martini Hospital for giving me the opportunity to write my master thesis. I would like to thank Peter Smit, the organizational manager of the RVE operating rooms and my special thanks goes to Ad van Beilen. During the conversations we had he gave me a lot of new insights and he stimulated me to think out of the box. Furthermore, I would like to mention the pleasant time I have had during my stay at the department Business Economic Affairs of the Martini Hospital, everyone was very interested and always in for a talk. Finally, I would like to thank all the people of the Martini Hospital that have cooperated to successfully finish this study.
For the support of the University, I would like to thank Pieter Kamminga. During the many meetings we have had he gave me helpful advice, this has resulted in a more improved structure and content of this master thesis. Last but not least I would like to thank my girlfriend, Irma. She was always prepared to read my master thesis and give comments, because of her motivating talks I can now be satisfied with the result of this master thesis.
Arjen Pen
Executive Summary
Due to the developments in the health care sector, the health care organizations have become increasingly complex over the past twenty years (Kuntz and Vera, 2005). To respond to the increasingly complex organizations this has led to a high degree of decentralization within the health care organizations. Within a hospital there are numerous internal transactions between the divisions. To evaluate the performances of the various divisions the use of transfer pricing is necessary in health care organizations.
This research is executed in the Martini Hospital in Groningen. To respond to the uncertain environment, the board of directors of the Martini Hospital started an organizational change process to a more decentralized structure. Therefore the organization is divided into result responsible units (in
Dutch: Resultaat Verantwoordelijke Eenheden (RVE)). Currently, the Martini Hospital consists of 19
RVEs of the primary process and 10 supporting RVEs. The RVEs of the primary process make use of the services provided by the supporting RVEs. Currently, the costs of the services provided by supporting RVEs are not charged to the users.
This research will focus on creating an adequate transfer pricing method between the supporting RVE operating rooms (which consist of the units clinic anaesthesia, anaesthesia, operating rooms, recovery, PBU and CSA) and the RVEs of the primary process which make use of the services of the supporting RVEs. The central research question of this thesis is:
What is an adequate transfer pricing method concerning the products and services from the different units of the RVE operating rooms of the Martini Hospital?
Based on these three contingency variables and the developed conceptual model in chapter three there can be made statements about which transfer pricing method is the optimal solution in the given situation. Currently, there does not exist a market price for the services which are provided by the RVE operating rooms. According to the conceptual model in chapter three, in the case that there does not exist a market price the organization should use a cost-based transfer pricing method. According to the four forms of asset specificity distinguished by Williamson (1986) there can be concluded that the degree of asset specificity of the Martini Hospital is high. According to the conceptual model, organizations with a high degree of asset specificity mainly make use of a cost-based transfer pricing method. Based on the four types of organizations distinguished by Eccles (1986) the Martini Hospital can be described as a cooperative organization. For a cooperative organization Eccles (1986) recommended mandated transfer prices based on a cost-based transfer pricing method. Based on these three contingency variables there can be concluded that the cost-based transfer pricing method is the optimal solution for the RVE operating rooms to internally transfer the costs to the users.
Table of content
LIST OF IMPORTANT ABBREVIATIONS ... 3
PREFACE ... 4
EXECUTIVE SUMMARY ... 5
TABLE OF CONTENT ... 7
INTRODUCTION ... 9
CHAPTER 1 DESCRIPTION MARTINI HOSPITAL ... 10
1.1HISTORY ... 10
1.2KEY INFORMATION ... 10
1.3MISSION MARTINI HOSPITAL ... 10
1.4VISION ... 11
1.5STRATEGY ... 11
1.6ORGANIZATIONAL STRUCTURE ... 11
CHAPTER 2 RESEARCH DESCRIPTION ... 13
2.1PREFACE RESEARCH OBJECTIVE ... 13
2.2RESEARCH OBJECTIVE ... 15
2.3RESEARCH QUESTION ... 16
2.4RESEARCH METHOD ... 17
CHAPTER 3 LITERATURE REVIEW ... 21
3.1TRANSFER PRICING METHOD ... 21
3.2OBJECTIVES OF TRANSFER PRICING ... 22
3.3TRANSFER PRICING METHODS ... 23
3.3.1 Market-based transfer prices ... 24
3.3.2 Cost based transfer prices ... 25
3.3.3 Dual rate transfer prices ... 25
3.3.4 Negotiated transfer prices ... 26
3.4BOUNDARY CONDITIONS FOR TRANSFER PRICING METHOD ... 27
3.5CONTINGENCY THEORY ... 28 3.6CONTINGENCY VARIABLES ... 29 3.6.1 Organizational variables ... 29 3.6.2 Environmental variables ... 32 3.6.3 Conclusion ... 32 CHAPTER 4 PRACTICE ... 35
4.1TRANSFER PRICING IN THE MARTINI HOSPITAL ... 35
4.1.1 Transfer pricing ... 35
4.1.2 Objectives of transfer pricing Martini Hospital ... 35
4.2CONTINGENCY VARIABLES MARTINI HOSPITAL ... 37
CHAPTER 5 REFINEMENT OF TRANSFER PRICING METHOD ... 40
5.1INTRODUCTION... 40
5.2UNIT CLINIC ANAESTHESIA ... 41
5.2.1 Service clinic anaesthesia ... 41
5.2.2 Costs Clinic Anaesthesia ... 41
5.2.3 Transfer pricing scenarios for the clinic anaesthesia ... 42
5.2.4 Conclusion ... 43
5.3UNIT ANAESTHESIA ... 43
5.3.1 Service unit anaesthesia ... 44
5.3.3 Transfer pricing scenarios for unit anaesthesia ... 44
5.3.4 Conclusion ... 47
5.4UNIT OPERATING ROOMS ... 47
5.4.1 Services operating rooms ... 47
5.4.2 Costs of unit operating rooms ... 48
5.4.3 Transfer pricing scenarios for the unit operating rooms ... 49
5.4.4 Conclusion ... 51
5.5UNIT RECOVERY ... 51
5.5.1 Services recovery ... 52
5.5.2 Costs of the unit recovery... 52
5.5.3 Transfer pricing scenarios for unit recovery ... 53
5.5.4 Conclusion ... 54
5.6OUTPATIENT TREATMENT UNIT ... 55
5.6.1 Services outpatient treatment unit ... 55
5.6.2 Costs outpatient treatment unit ... 55
5.6.3 Transfer pricing scenarios for outpatient treatment unit ... 56
5.6.4 Conclusion ... 57
5.7CENTRAL STERILE DEPARTMENT ... 58
5.7.1 Services Central Sterile Department ... 58
5.7.2 Costs of the Central Sterile Department ... 58
5.7.3 Transfer pricing scenarios for Central Sterile Department ... 58
Introduction
Vancil (1979, pp 142) ‘My third disappointment in this study is that I have been unable to say
anything definitive on the subject of transfer prices … the issue remains a perennial puzzle for academics, while practitioners continue to cope. I wish the best of good fortune to the next researcher to tackle this problem’.
This study is about transfer pricing in hospitals, especially to develop a transfer pricing method for the operating rooms to charge the users of the operating rooms. Although there are published several scientific articles about transfer pricing in the public sector there is done relatively few scientific research to transfer pricing in hospitals. The published scientific literature about transfer pricing is primarily based on profit organizations and not on non-profit organizations. According to Asselman (2008) who is working at the Academic hospital of Amsterdam there is an increasing requirement to value the internal transaction within a hospital. This research is of interest, because it shows that there is done little research to transfer pricing in the non-profit sector and especially to transfer pricing within hospitals. Therefore, this research will focus on the transfer pricing problem within hospitals and especially aimed at the operating centre within a hospital. According to the above statement of Vancil (1979) the transfer pricing problem is an often researched topic and continues to be a puzzle for academics. Even though, this research attempts to provide an answer to the following research question:
What is an adequate transfer pricing method concerning the products and services from the different units of the RVE operating rooms of the Martini Hospital?
Chapter 1 Description Martini Hospital
Initially in this chapter there will be given an introduction about the Martini Hospital in general. The relevant features such as the mission and vision and strategy of the Martini Hospital are described. Finally the current organizational structure will be explained. The intention of this chapter is to provide an insight in the Martini Hospital, where the practical research has occurred.
1.1 History
The Martini Hospital is a large general hospital in Groningen, it resulted from a merger between the common Christian Diakonessenhuis on the Van Ketwich Verschuurlaan and the Roman Catholic Hospital on the Van Swietenlaan in 1991. The main reason for the merger was the assumption that a large general hospital would be better able to deliver top-level clinical care. Because of the merger, the hospital was situated on two locations in the city Groningen. During the merger there was also the intention to move to one location and the building of a new hospital since that time has been a central issue. In 2007 the building of a new hospital was completed, the two locations merged into a new Martini Hospital on the former location situated at the Van Swietenlaan. Because of the renovation of the old building of the Van Swietenlaan, there are still some clinics and staff departments working at Location Ketwich. Once the renovation of the Van Swietenlaan is completed, location Ketwich will disappear.1
1.2 Key information
The Martini Hospital is a general hospital and offers a wide range of specialist medical care, the hospitals offers 27 specialities and there are 580 available beds for patients. In 2008 the staff consisted of 2,400 employees with the exception of the medical specialists. In the year 2008 there were 32,170 surgeries performed in the curative care within the Martini Hospital and total operating income for the year 2008 was € 185.368.0002
1.3 Mission Martini Hospital The Martini Hospital offers:
ü Care adjusted to the individual patient ü Quality which is controllable
ü A high service level
ü A patient friendly and safe environment ü An environment where employees are inspired ü Possibility for education and research
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From website martini Ziekenhuis: www.martiniziekenhuis.nl, 2010 2
From this framework the hospital develops new priorities for top-level clinical care and in collaboration with care partners realizing efficient, continuous and innovative care chains.
1.4 Vision
The Martini Hospital is the top-level clinical hospital for patients, referrers, insurers and health care partners. Education and research are integrated into excellent 2nd line healthcare. Employees are working in learning and stimulating environment with clear agreements.
The mission and vision translates the core values of the Martini Hospital in being a reliable, committed and open partner. It is important to handle the major challenges in the coming years, such as working of the market, capital costs, extending the DBC segment, a tight labour market, higher costs and lower budgets and increased demand on education and research. Therefore the following long-term strategy is formed from 2007 – 2012.
1.5 Strategy
The strategic choices of the Martini Hospital are operationalized into measurable objectives: ü Excel as a 2nd line health care institution and the first choice hospital
There exist changes to make the Martini Hospital more attractive for patients and referrers. The hospital could increase its market share to offer care based on the requirements of the patients.
ü Further development of top-level clinical care
The Martini Hospital is a major healthcare provider in the region, with many specialties. This offers opportunities to expand top-level clinical care. Opportunities are elderly care, oncology, neurosurgery and integrated care.
ü To organize education as a quality image around the basic care
The Martini Hospital is a teaching hospital. Education and research should contribute to the quality image of the Martini Hospital.
ü Further development of integrated Tran mural care
There are many market opportunities to anticipate on the waiting lists of the market. ü Maintain the relation between the doctors and the surgeons
The short lines between the doctors and the surgeons in the Martini Hospital are one of the strengths of the hospital. Therefore these relationships should be maintained or improved3.
1.6 Organizational structure
The board of directors started in 2009 an organizational change process; centrally to this concept is the change in structure and control. More decentralized responsibilities in smaller units, so called result oriented responsibility centres (In Dutch Resultaat Verantwoordelijke Eenheid: RVE). A RVE is an organizational unit, organized around the primary process of the Martini Hospital. The RVE is led by a
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medical and an organizational manager, this duo management together constitutes the decisions of the partnership of the surgeons and the board of directors for taking responsibility for their RVE. The board of the RVE makes arrangements with the board of directors about targeted production and to achieve the budget. The primary process of the hospital is divided into 19 RVEs:
ü Cardiology ü Surgery ü Dermatology
ü Gynaecology/ obstetrics ü Internal health care
ü Ear, nose and throat care (In Dutch: Keel Neus Oor (KNO)) ü Paediatrics
ü Pulmonary
ü Gastro-intestinal and liver diseases ü Mouth diseases, jaw and facial surgery ü Neurosurgery ü Neurology ü Ophthalmology ü Orthopaedics ü Plastic surgery ü Rheumatology ü Rehabilitation care ü Urology ü Burns centre
The units that support the primary process are classified in the following ten RVEs: ü Clinical Neurophysiology
ü Clinical Psychology ü Emergency rooms ü Intensive care
ü Medical Centre Service
ü Operating rooms, outpatient, anaesthesia, recovery and CSA ü Pathology
ü Pharmacy and clinical pharmacy ü Psychiatry
ü Radiology, nuclear care4
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Chapter 2 Research description
In this chapter the research design of this master thesis will be explained. Firstly there is an introduction of the subject, subsequently the incentives for research and the objective of this research are explained. Furthermore, there will be described the research question and the sub questions which are handled in chapter three to five. Finally there will be a description of the research method which is used during this research for the master thesis.
2.1 Preface research objective
Due to the ageing population and pharmaceutical developments in the healthcare sector in the Netherlands, the costs of the health care has increased rapidly in recent decades. Complaints that were previously difficult to treat are with the available medication and equipment nowadays enhanced to be treated better. Previously, hospitals were funded by using a functional budgeting system. The budget allocated to the hospital was based on:
ü capital costs ü location costs
ü wage costs of employed medical specialists ü an amount per adherent inhabitant
ü an amount per weighted port specialist
ü an amount for production agreements about admissions, inpatient days, nursing days, first visits and top clinical health care
Because these budget parameters have no direct relationship with the production of the hospital, it provides not an incentive for production optimalization and innovation is insufficiently encouraged. As a result the Functional Budgeting system gives little transparency and incentives to efficiency (Os et al., 2004).
Therefore the Dutch government introduced Diagnosis-Treatment-Combinations (In Dutch Diagnose-Behandelings-Combinaties (DBCs)). A DBC can be defined as: ‘The sum of activities performed by the hospital and the specialist, as a result of the question for care with which the patient consults the specialist in the hospital. The activities contain medical and medical supporting activities, as well as clinical and outpatient activities’ (Crom, 2005).
compare the hospitals with each other and to base their choice for a hospital on these factors. The main purpose of the government is to provide a high quality, cost efficient and a safe health care in the Netherlands. To realize this, the government desires to leave the care to the health care market. The DBC systematic is a prerequisite to move the health care sector to a regulated market. With the ultimate goal that hospitals compete with each other on the quality and costs of the health care. To create a market, health insurers should negotiate with the care provider about the price and the quality of the care. For the patient the DBC systematic will provide them with more insights into the costs of care and the quality of care provided by the different hospitals5.
Beforehand hospitals were accountable to the government for the costs they made. Currently, since the implementation of the DBCs the hospitals should negotiate with the health insurance company for their compensation for the DBCs. The health insurance company pays a fixed price per DBC for the activities which are provided to the patient. For that reason hospitals should be better aware of the costs of the activities at all levels within the organization.
Due to the developments in the health care sector, the board of directors of the Martini Hospital has started an organizational change process. The essence of the organizational development lies in increasing the market and result orientation of the hospital. Centrally in this concept is the transformation to a more decentralized organization. Responsibilities are divided into smaller units, these are called Result Responsible Units (in Dutch Resultaat Verantwoordelijke Eenheden RVEs)6. Decentralization is to shift tasks, responsibilities and competences from the board of directors and the directors to another level in the organization (Jones, 2006). This means more liberty to take decisions at a lower level; on this level the decisions can be made properly, because here there is an overview of the implications of the decisions. An additional definition for decentralization is the spread of power from higher to lower levels in a hierarchy (Monrad, 1997). Decentralization is viewed as a response to an uncertain environment, because a decentralized organization can react quicker and more adequate on environmental and organizational changes (Watson and Baumler, 1975). The hospital is divided into 19 RVE which are representing the primary process of the hospital and 10 supporting RVEs which supports the RVEs of the primary process. Each RVE is lead by a medical and an organizational manager. The medical manager is a part time function and is done by a member of the relevant partnership. The major part of the surgeons are not employed by the hospital but are represented in a partnership. To increase the involvement of the partnership with the objectives of the hospital, there will be a medical manager, which is a representative of the partnership, in the management of the RVE.
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Information from website: www.dbconderhoud.nl 6
2.2 Research objective
Due to the increasing pressure on financial resources, changes in the funding and the increased social accountability, hospitals in the Netherlands are confronted with a high degree of uncertainty (Asselman, 2008). To respond to the uncertain environment and increase the efficiency, the board of directors of the Martini Hospital started an organizational change process to a more decentralized organization structure. Therefore the company is divided in RVEs of the primary process and supporting RVEs. The RVEs of the primary process are making use of the services of the supporting RVEs (e.g. operating rooms, laboratory and radiology).
The Martini Hospital consists of 19 RVEs of the primary process and 10 supporting RVEs. This research will concentrate on the internal transactions between the RVE operating rooms and the RVEs of the primary process which are making use of the services of the RVE operating rooms. The RVE operating rooms is a supporting RVE which is divided into six units. The RVE operating rooms consist of the units: Clinic anaesthesia, unit anaesthesia, outpatient treatment unit, unit operating rooms, recovery and Central Sterile Department. Each unit provides products or services for the RVEs of the primary process.
The following organization scheme illustrates the structure of the RVE operating rooms:
Figure 1: Organization scheme RVE operating rooms
these internal transactions and ultimately this could lead to a more efficient use of the services provided by the supporting RVEs.
2.3 Research question
This research will focus on creating an adequate transfer price method between the supporting RVE operating rooms and the RVEs of the primary process which make use of the supporting RVE operating rooms. This has led to the following research question:
What is an adequate transfer pricing method concerning the products and services from the different units of the RVE operating rooms of the Martini Hospital?
Sub questions
In the published scientific literature about transfer pricing there are mentioned several objectives of transfer pricing. To make a distinction between the main objectives of transfer pricing according to the published scientific literature the following sub question is formulated and discussed in chapter three of this research.
1. What are the main objectives of transfer pricing according to the literature?
In the published scientific literature about transfer pricing there are distinguished several transfer pricing methods. To make a distinction between the various transfer pricing methods the following question is formulated and discussed in chapter three of this master thesis.
2. Which transfer pricing methods are distinguished in the literature?
The aim of the following question is to provide an answer to the choice of a transfer pricing method in a specific situation. By using the published scientific literature this question determines the suitability of the in question two mentioned transfer pricing methods in a specific situation. Ultimately, this question should lead to a conceptual model for the choice of a transfer pricing method by using different contingency variables. For this reason the following question is formulated and discussed in chapter three of this master thesis.
3. How do the contingency variables determine the suitability of a transfer pricing method?
board and the unit managers of the RVE operating rooms the main objectives of transfer pricing of the board of the operating rooms are expressed. Therefore the following question is formulated and discussed in chapter four of this master thesis.
4. What are the main objectives of the board of the RVE operating rooms to achieve with the transfer pricing method?
Based on the contingency variables mentioned in chapter three the following question attempts to identify the transfer pricing method which is most suitable for the Martini Hospital. This question is discussed in chapter four of this master thesis.
5. What is according to the conceptual model an adequate transfer pricing method given the specific situation for the Martini Hospital?
In chapter four there is determined which transfer pricing method is applicable to the Martini Hospital. There are several possible variations for each transfer pricing method (i.e. a cost-based transfer pricing method could be based on variable costs, integral costs, integral costs with a profit allowance etc.), therefore the following question will provide different scenarios for the refinement of the transfer pricing method for the Martini Hospital. The refinement of the transfer pricing method means how the costs of the six units of the RVE operating rooms could be internally allocated to the RVEs which are making use of the services provided by the RVE operating rooms. There are several possibilities to allocate the costs of the units of the RVE operating rooms to the users. Therefore this question will look at the specific situation for the units of the RVE operating rooms and provides different scenarios how the costs could be internally transferred to the users. This question is discussed in chapter five.
6. What could be scenarios for the specific filling in of the transfer pricing method for the different units of the RVE operating rooms?
2.4 Research method
pricing method should be implemented to better evaluate the performances of the RVEs of the primary process.
Data collection
The researcher stayed from December 2009 until June 2010 at the Martini Hospital to investigate the transfer pricing issue at the Martini Hospital in Groningen. During this stay, the researcher had the possibility to better understand the process which takes place at the operating rooms in the Martini Hospital, the researcher has had guided tours in the operating rooms of the Martini Hospital. During these guided tours through the different units the researcher will observe the various activities which take place at the operating rooms. Caused by the observations the researcher will obtain a better understanding of the environment. During the guided tours there will be made notes, according to Baarda and De Goede (1990) it is important with observations to make immediately notes because otherwise several observations will not be remembered. An advantage of observations above interviews is that the actual behaviour is determined. In an interview it is always the question if the behaviour of the interviewee is correctly represented (Baarda and De Goede, 1990). After the guided tours there will be an interview with the unit manager. During these interviews the observations of the guided tours could be checked.
The Result Responsible Unit (RVE) operating rooms consist of different units: Clinic anaesthesia, Anaesthesia, Outpatient treatment unit, Operating rooms, Recovery, and the Central Sterile Department. Each unit is represented by a unit manager, the operating rooms are represented by two managers. Accordingly, there are held seven interviews with the directly involved unit managers of the operating rooms regarding how to calculate a proper transfer price for the users. The interviews held with the unit managers took about one until one and a half hour. In accordance with Baarda and De Goede (1990) there are several advantages and disadvantages of interviews. An interview is an appropriate technique in the case of knowledge, attitudes and opinions. A disadvantage is that interviews often provide less reliable information than observations. Oral interviews are chosen instead of written interviews, because an oral interview provides better opportunities for open and complicated questions.
the Canisius Wilhelmina Ziekenhuis, the Medisch Spectrum Twente, and the St. Antonius Hospital. The financial directors were asked by mail what the exact status was of the transfer pricing problem between the operating rooms and the users of the operating rooms.
The foundation Santeon focuses on sharing and pooling of knowledge, talent and skills. The foundation could also provide a cost saving in the area of for example purchasing, research, education and automatization. The researcher will contact the financial directors of each hospital and exchange information about how these cooperative hospitals handle with the transfer pricing at the operating rooms. The gathered information will be used to form a vision for the transfer pricing method within the Martini Hospital.
Furthermore, during the final weeks of the master thesis at the Martini Hospital there was held a discussion with the unit managers, the organizational manager of the operating rooms, and the personnel of the department of business economic affairs. During a presentation the researcher showed the results of the investigation and subsequently discussed these results with the people present. This discussion took one hour and the results are processed in the master thesis.
Type of research
According to De Leeuw (1990) the difference between scientific and practical research is that scientific research contributes to the general knowledge of Business Administration and that practical research provides knowledge to a client. De Leeuw distinguishes five types of research:
ü Pure scientific research
Pure scientific research produces theories, concepts, methods and tools for the society or the scientific community. At the time of investigation there are no practical problems associated with the research.
ü Socially relevant research
Socially relevant research attempts to create knowledge for a socially relevant phenomenon at this time or in the future.
ü Policy relevant research
Policy relevant research investigates a general problem in practice for specific clients. An example of policy relevant research is a prototype.
ü Policy supporting research
Policy supporting research attempts to provide knowledge to clients which are functional in specific situations. Products of policy supporting research are statements, concepts, approaches and tools.
Problem solving research considers the entire problem of the client and attempts to provide an answer on the total need of knowledge of the client. Problem solving research attempts to analyse the total problem and come with solutions.
Chapter 3 Literature review
The major goal of this chapter is to provide an answer to the research question from a theoretical perspective. In the first paragraph the idea behind transfer pricing will be explained. In the subsequent paragraph the main objectives of transfer pricing will be described. In the following paragraph the transfer pricing methods distinguished in the literature will be given. Finally there will be explained how the suitability of the transfer pricing methods is influenced by the contingency factors.
3.1 Transfer pricing method
A transfer pricing problem arises in a divizionalized organization. If within an organization goods or services are provided between divisions there exists a transfer pricing problem (Borkowski, 1990). In the literature there exists several definitions for transfer pricing, in this paragraph there will be depicted various definitions.
According to Abdel Khalik (1974) a transfer pricing method attempts to create prices for internally produced and consumed products. A more comprehensive definition of transfer pricing by Thomas (1980) describes a transfer price as a monetary valuation placed on divisional outputs which are also the inputs of another division within the same organization.
McAulay and Tomkins (1992, pp 102) define a transfer price as ‘the value placed on the goods or services which are traded between divisions of an organization’. They describe the major transfer pricing problem as the search for a particular transfer pricing policy that will be the most favourable in a specific situation.
Horngren and Foster (1994, pp 864) define a transfer price as ‘the price one subunit (segment, department or division) of an organization charges for a product or service supplied to another subunit of the same organization’. In the preferable situation the transfer pricing method should direct each manager to create optimal decisions for the entire company.
3.2 Objectives of transfer pricing
Transfer pricing has several organizational objectives, these objectives can be classified in three main categories. In this subsection, by using these three main categories the major objectives of transfer pricing will be described.
1. Providing economic signals
According to Merchant and Van der Stede (2007) the first objective of transfer pricing is providing accurate economic signals to the managers of the supplying and buying division. If a good or service is without charge the users are not motivated to consider its value. The buying division tends to demand goods or services as much as they can obtain and do not consider the value of the goods or services (Anthony, 1980). Abdel Khalik (1974) relates the objective of transfer pricing to the efficient allocation of resources. For example, if the transfer price is too low it will result in a higher profit for the buying division. This ultimately can lead to a too high allocation of goods or services to the division, from the company’s point of view. ‘The objective of transfer pricing is to find the transfer price which will lead both the selling and buying divisions to choose output levels that maximize the total profits of the firm’ (Eccles, 1986, pp 21).
Organizations which are divisionalized and where products or services are transported between the internal divisions need a transfer price for the products or services to measure the divisional profitability (Hirschleifer, 1956). According to McAulay and Tomkins (1992) transfer pricing may be seen as a precondition for supporting entrepreneurial activity by the divisional managers. With transfer prices the central management attempts to motivate the divisional manager to think similar to an entrepreneur.
2. Informational function
A second purpose of transfer pricing is providing information about the performances of the managers. Transfer prices are useful to evaluate the performances of the managers of the supplying and buying division (Merchant and Van der Stede, 2007). A company which is divisionalized and wants to measure the profitability of the divisions will need to develop internal transfer prices for the internally transferred products or services.
3. Move profits between divisions
According to Abdallah (1988) the objectives of transfer pricing can be divided into domestic and international objectives. The international aspects of transfer pricing arises just in the case when a multinational corporation is involved. The international objectives of transfer pricing are according to Abdallah (1988, pp 61) ‘less taxes, duties and tariffs, less foreign exchange risks, better competitive position, and better governmental relations’. Because this research will focus on a Dutch hospital the international objectives of transfer pricing will not be taken into account. The domestic objectives of transfer pricing are according to Abdallah (1988, pp 66) ‘greater divisional autonomy, greater motivation for managers, better performance evaluation, and better goal congruence’. Due to greater divsional autonomy the organization attempts to stimulate entrepreneurship of the division managers.
3.3 Transfer pricing methods
There are described several transfer pricing methods in the scientific literature. In this subsection there will be an overview of the several transfer pricing methods distinguished in the literature. According to Van der Meer-Kooistra (1994) by looking at the different elements of transfer pricing methods and the differences between the elements of the transfer pricing method there could be distinguished numerous transfer pricing methods. To maintain an overview she developed a model based on two typical characteristics. According to this model there can be distinguished eight types of transfer pricing methods. This overview is expressed in figure two, which can be found on the next page of this master thesis. This master thesis will use the model of Van der Meer-Kooistra (1994) because this model provides a good overview of the transfer pricing methods available in the scientific literature.
According to Van der Meer-Kooistra (1994) there can be made a classification of transfer pricing methods based on two typical characteristics of the internal transactions:
1. The degree of delegation of competences: to what extent can division managers make their own decisions about the control of internal transactions. According to figure two there are two major questions which should be answered to measure the degree of delegation of competences. The first question which should be answered is if the internal transactions are mandated. The second question from figure two deals with if the transfer price is prescribed. A prescribed transfer price exists when a higher management level than the management of the internal divisions are prescribing the rules for the transfer pricing method.
market based transfer price, a cost based transfer price, a dual rate transfer price, and a transfer price based on negotiations.
Figure 2: ‘ Figure 3.2 from J. Van der Meer-Kooistra (1994) pp 68 overview of the different transfer pricing methods’.
Both characteristics of the transfer pricing method are basic characteristics for the transfer pricing method. According to Van der Meer-Kooistra (1994) based on these two basic characteristics there can be distinguished eight types of transfer pricing. Figure two shows that there could be distinguished four bases for the transfer price. A market-based transfer price, a cost-based transfer price, a dual rate transfer price, and a transfer price based on negotiations. Therefore, in the following subsections these four bases are explained.
3.3.1 Market-based transfer prices
3.3.2 Cost based transfer prices
Cost based transfer pricing methods include marginal and full cost transfer pricing methods, including full cost plus an additional mark-up. These forms of cost based transfer pricing methods are explained in the following subsection.
Marginal cost transfer prices
A transfer price can also be based on the marginal costs; the marginal costs are the variable or direct costs of production. An advantage of the marginal cost transfer pricing method is that the contribution margin generated by the division could be effortlessly determined. The total contribution can be calculated by deducting the selling price of the final product with the marginal cost of the last production or service process stage. However, the marginal cost transfer price method offers poor information for evaluating the economic income of either the selling or buying division. For the selling division this means that they are confronted with losses because they only are compensated with the variable costs and not for the fixed costs. In contradiction, the buying division does not have to pay the full costs of production and therefore the profits of the buying division are overstated (Merchant and Van der Stede, 2007).
Full-cost transfer prices
An additional method is the full-cost transfer price, whereby the full costs of the product or service are charged to the buying division (Merchant and Van der Stede, 2007). The full-cost transfer price method is used by most of the companies because it has several advantages. This method provides the company information for the long term, because these costs should be at least recovered by the purchasing division to be profitable as a company. Another advantage of this method is the simple implementation, because organizations mainly have a good insight in the total costs of the product or service. Finally, the method is a proper evaluation instrument because the selling division is allowed to recover at least the full cost of the product or service (Merchant and Van der Stede, 2007). An extension of the full cost transfer price is the full cost plus a mark-up, the full costs of the product or service is expanded with a mark-up. The selling division therefore is authorized to gain revenue on internally transferred products or services (Merchant and Van der Stede, 2007).
3.3.3 Dual rate transfer prices
between the managers of the buying and selling division. The selling division is compensated with a corporate subsidy and for the buying division it is advantageous to purchase their products internally. The result of the dual rate transfer pricing method is that the operating income of the entire organization is less than the sum of the operating incomes of the divisions. The dual rate transfer pricing method is not a method which is extensively used in practice because there are several disadvantages. A disadvantage of this method is that the manager of the supplying division could not have adequate motivation to control the costs of the division.
According to McAulay and Tomkins (1992) the dual transfer pricing method is a form of an ad hoc approach. If a single transfer price cannot meet all the transfer pricing objectives, the use of two different transfer prices might be able to achieve the organization’s objectives for both the selling and buying division.
3.3.4 Negotiated transfer prices
Furthermore, the transfer price can be the result of the negotiation process between the managers of the selling and the purchasing division (Merchant and Van der Stede, 2007). This method is only effective if the selling division has opportunities to sell its product to external customers and the purchasing division has the opportunity to buy the product of external suppliers. According to Emmanuel and Mehafdi (1994) this method encourages independence, entrepreneurship and teamwork, and ultimately realizing the optimal organizational result. Nevertheless, the disadvantages of negotiated transfer prices are the time used by the management for the negotiation process, the negotiation of transfer prices can be harmful for the relation between the managers of both divisions, and finally the price depends on the negotiating skills and bargaining power of the managers involved. In the case that a division has some good outside selling opportunities but the other division does not have buying opportunities, the bargaining power will not be in balance (Merchant and Van der Stede, 2007). Horngren and Foster (1994) have developed a general guideline for setting up a minimum transfer price.
Figure 3: General transfer pricing rule Horngren and Foster (1994, pp 875)
According to Seal et al. (2006) if the transfer price is the result of the negotiation process the exact transfer price could not be predicted. However, the range for an acceptable transfer price can be calculated. From the perspective of the selling division the lowest acceptable transfer price will be:
Figure 4: Minimum acceptable transfer price (Seal et al. 2006, pp 719)
From the perspective of the buying division the highest acceptable transfer price will be:
Figure 5: Maximum acceptable transfer price (Seal et al. 2006, pp 719)
Ultimately there can be predicted that the result of the negotiation process between the selling and the buying division will somewhere between the minimum acceptable transfer price of the selling division and the highest acceptable transfer price of the buying division.
With the negotiated transfer price method the division managers are free to negotiate whether intercompany transfers take place, the number of transferred products and the transfer price of the product (Vaysman, 1998).
3.4 Boundary conditions for transfer pricing method
In this subsection there will be given several boundary conditions for the transfer pricing method of the RVE operating rooms according to Asselman (2008).
The transfer pricing method is part of the total management control system of the Martini Hospital. It is an instrument to achieve the objectives of the Martini Hospital and the transfer pricing method but should not cause unwanted effects. Therefore the transfer pricing method should pay attention to the following boundary conditions (Asselman, 2008):
ü The transfer pricing method should not lead to erroneous medical substantive choices on the basis of money. As a result the quality of care should not be negatively affected.
ü The transfer price should be valid, the transfer price should be a fair system, transparent and accepted by the board and users of the operating rooms.
ü The transfer pricing method should not result in unnecessary bureaucracy. Procedures for transfer pricing should be simple and clear and there have to be minimal administrative duties. ü The transfer pricing method should not lead to suboptimal behaviour of internal customers. The internal customers are part of the total organization and should act in the organizational interests.
ü The board of directors of the hospital should support the objectives of the transfer pricing method to the users. The board of directors has to communicate the necessity of the transfer pricing method to the employees of the hospital.
3.5 Contingency theory
In this paragraph the contingency theory of Otley (1980) will be explained, furthermore the contingency theory in relation with transfer pricing will be described. First the general contingency theory will be explained followed by the applicability of the contingency theory to transfer pricing.
According to Seal et al. (2006, pp 482) ‘The contingency theory is an approach that argues that there is no one best organizational structure or management accounting technique but emphasizes the fit with factors such as task, product and levels of environmental uncertainty’.
Otley (1980) is the patriarch of the contingency theory. In his research he stated that scientific articles before 1960 supposed that organizations could be understood separately from their environment. After 1960 the scientific articles more and more recognized that organizations were mutually dependent with their environments. To explain the contradictory observations which were discovered in the scientific articles before 1960, there was a movement from a more universalistic to a contingent approach in management accounting. According to Otley (1980, pp 413) ‘the contingency approach to management accounting is based on the premise that there is no universally appropriate accounting system which applies equally to all organizations in all circumstances’.
In the literature the link between the contingency theory and the different available transfer pricing methods is established. Corresponding to McAulay and Tomkins (1992, pp 112) ‘Contingent approaches suggest specific transfer pricing policies for specific managerial situations’. Emmanuel and Mehafdi (1994) stated that the transfer pricing problem is situation-specific and thus requires situation-specific solutions. Due to certain characteristics of human behaviours (e.g. bounded rationality, opportunism) the optimal answer to the transfer pricing problem will be a compromise solution. In addition, Borkowski (1992) mentioned that every division is determined by the unique combination of environmental, international, and organizational characteristics of a Multi National Company. Therefore, the optimal transfer price is situation specific and each company should choose the optimal transfer price for any given situation.
3.6 Contingency variables
There are several variables which could influence the choice of a transfer pricing method. Eccles (1985), Borkowski (1990), Van der Meer-Kooistra (1994) and Colbert and Spicer (1995) have investigated which contingency variables could provide a contingent solution for the transfer pricing problem. The contingency variable is the independent variable which influences the dependent variable, the transfer pricing method chosen. This paragraph provides an answer to which transfer pricing method is most adequate given a particular situation. Borkowski (1990) classified the several significant variables which influence the choice of a transfer pricing method into three main categories: organizational, environmental, and international. Because this research is about transfer pricing methods within hospitals in the Netherlands the international variables do not influence the choice of the transfer pricing method. Therefore the contingency variables which will be investigated in this research can be classified into environmental and organizational variables. Ultimately there will be made conclusions based on these contingency variables if the market based, cost-based, dual rate transfer pricing or negotiated transfer pricing method is applicable in the given situation. These conclusions are processed into the conceptual model at the end of this paragraph.
3.6.1 Organizational variables
Vertical integration and diversification
Eccles (1986) derived an analysis comprising recommendations based on two variables: vertical integration and diversification. He distinguished four types of organizations and subsequently provides recommendations about the transfer pricing method for these organizations. Eccles (1986) proposed that the transfer pricing method was dependent on the organizational strategies of vertical integration and diversification.
Eccles (1986, pp 273-279) distinguishes four types of organizations, for each organization type Eccles comes with a recommendation for the transfer pricing method. The four types of organizations are:
1. Collective organization
The collective organization has a low vertical integration and diversification. This type organization is typical for small and new firms, the strategy of these organizations is based on the vision of the owner/entrepreneur and there is not extensive management control system. In this type of organizations there are not internal transactions and therefore there is not a transfer pricing policy for the collective organization.
2. Cooperative organization
The cooperative organization has a high vertical integration and low diversification. Because of the close relationship between the different divisions it is necessary that the divisions have a common strategy that is in the total interest of the organization. In the cooperative organization there are various internal transactions. According to Eccles the transfer pricing policy which fits for the cooperative organization is mandated internal transactions against full costs.
3. Competitive organization
The competitive organization has a low level of vertical integration and a high diversification. The divisions within the organization are profit centres and compete with each other for capital and other resources on the basis of the performances of the divisions. In the competitive organization there are relative little internal transactions. The transfer pricing policy for this type of organization is characterized by non-mandated internal transactions against transfer prices which are defined by the divisions themselves.
4. Collaborative organization
Asset specificity
Asset specificity is described in the transaction cost theory by Williamson (1985). Asset specificity implies that when a supplying organization or division (seller) has made very specific investments for the buying organization or division (buyer), the seller has a major importance to hold on the relationship with the buyer. The seller just wants to make specific investments if the costs of these specific investments are largely covered by the buyer.
Williamson (1985) distinguishes four forms of asset specificity:
1. Site specificity: occurs ‘when there are advantages in successive production stages located in close proximity to one another’ (Van der Meer-Kooistra, 1994, pp 131).
2. Physical asset specificity: occurs when there have been made investments in tangible assets especially for the specific needs of the buyer (Williamson, 1985)
3. Human asset specificity: occurs from learning by doing, which consequently increases the knowledge of participants about specific activities. (Williamson, 1985)
4. Dedicated assets: are substantial investments in production capacity but the investments are not for a specific buyer. However, when the buyer discontinues his demand, the organization cannot effortlessly find a new buyer for the gone capacity. (Williamson, 1985)
Based on the transaction theory of Williamson (1985) different scientific researchers (i.e. Van der Meer-Kooistra (1994); Colbert and Spicer (1995)) have established a link between the degree of asset specificity and the transfer pricing problem. Because a high degree of asset specificity results in seller and buyer being strongly dependent on each other, the degree of asset specificity also have influence on the transfer pricing method chosen.
Van der Meer-Kooistra (1994) investigated the link between a high degree of asset specificity and the transfer pricing issue concerning the selling and buying division. If there exist a high degree of asset specificity the continuity of the internal transactions is considered especially important. In order to guarantee the continuity of the internal transactions the transfers between these divisions will be mandated. If there exists a low degree of asset specificity the continuity of the internal transactions are considered less important and therefore the buyer and seller are liberated to decide if they search for outside suppliers or buyers.
just a rough estimation of the value of the internally transferred product or service. In the case that the investigated division had a low degree of asset specificity there is used frequently a market-based transfer pricing method.
3.6.2 Environmental variables
The environmental variable which is investigated by several researchers (i.e.Solomons (1965), Anthony et al. (1984), Borkowski (1990), and Vaysman (1998)) is the existence of a market price. These researchers have investigated the relation between the existence of a market price and the transfer pricing method chosen. Ultimately, based on this variable there can be made a choice for a transfer pricing method
In the case that there exists a competitive market for the products and the buying division has several opportunities for buying by outside suppliers, according to Solomons (1965) the solution for the transfer pricing problem is to base the transfer price on the market value of the products or services.
Market prices are sometimes unavailable, inappropriate, or too costly to obtain for transfer pricing. The product may be specialized or unique, price lists may not be available, or the internal product may be different from the products externally available in terms of quality and service. In these cases, many organizations use cost-based measures as transfer prices (Vaysman, 1998).
Anthony et al (1984) have pointed out in their research that if there are products or services transferred between divisions within one organization and there are not external suppliers for the products or services. According to Anthony et al (1984) the solution for the transfer pricing method is a form of the cost-based method a standard cost plus a profit allowance.
3.6.3 Conclusion
transactions and for these organizations negotiations is the optimal solution for the transfer pricing method. The collaborative organization has a high level of vertical integration and a high diversification. The management control system are complex and for these type organization there is recommended a market based transfer pricing method.
Furthermore, the relation of asset specificity and the choice of a transfer pricing method is investigated. A high asset specificity results in that the buyer and seller are strongly dependent of each other there is recommended a cost-based transfer pricing method. If the degree of asset specificity is low there is recommended a market-based transfer pricing method. In addition if the degree of asset specificity is low there is recommended a market-based transfer pricing method, however the transfer pricing method of negotiations is also possible in this specific situation.
In addition the link between the existence of a market price and the choice of a transfer pricing method is investigated. If there exists a market price there is recommended a market-based transfer pricing method and if there does not exists a market price there is recommended a cost-based transfer pricing method. Besides that there is recommended a market based transfer pricing method if there exists a market price there can be a transfer pricing method based on negotiations.
Finally, according to Van der Meer-Kooistra there are four bases for the transfer pricing problem. These four bases are integrated into the conceptual model, however according to the investigated contingency variables the dual transfer pricing method is not in a single case a possible solution for the transfer pricing issue.
Chapter 4 Practice
In chapter four the transfer pricing problem within the Martini hospital will be expressed by using the literature from chapter three. In the first paragraph the transfer pricing problem within hospitals is explained. Furthermore, the objectives of the board of the RVE operating rooms are discussed. Subsequently, based on the interviews with the unit managers and the experiences during the investigation in the Martini Hospital the contingency variables mentioned in chapter three are elaborated for the Martini Hospital. Ultimately this should lead to a choice between a cost-based transfer pricing method, a market based transfer pricing method, a dual rate transfer pricing method or transfer pricing based on negotiations.
4.1 Transfer pricing in the Martini Hospital
Firstly there will be explained if there exists a transfer pricing problem within the Martini Hospital, subsequently, the major objectives of transfer pricing for the Martini Hospital are described.
4.1.1 Transfer pricing
To react to the increasingly complex environment the Martini Hospital started an organizational change process into a more decentralized structure. In the Martini Hospital there are represented divisions (RVEs) of the primary process and divisions (RVEs) which support the RVEs of the primary process. The supporting RVEs provides services to the RVEs of the primary process. This research will focus on the RVE operating rooms which consists of six supporting units which provide services to the RVEs of the primary process. According to the literature a transfer pricing problem arises in a decentralized organization where goods or services are provided between divisions of the same company (Abdel Khalik, 1974). Within the Martini Hospital the RVEs of the primary process make use of the services of the supporting RVEs and therefore there exists a transfer pricing problem within the Martini Hospital.
4.1.2 Objectives of transfer pricing Martini Hospital
According to the literature transfer pricing has several organizational objectives, in the previous chapter the objectives are classified into three main categories:
1. Providing economic signals 2. Informational function
3. Move profits between divisions
1. Providing economic signals
According to Merchant and Van der Stede (2007) the first objective of transfer pricing is to provide accurate economic signals to the managers of the supplying and buying division. At the Martini Hospital the operating time available at the operating centre is a bottleneck. This operating time should be used efficiently by the RVEs which are making use of the operating centre. In this case a transfer price could provide an economic signal to the user of the operating centre. Ultimately, this economic signal could lead to more awareness of the value of the services and in the long run to a more efficient use of the services from the RVE operating rooms.
In addition, there should be considered if there should come two different transfer prices for elective and emergent operating time. Elective operating time is the time for scheduled surgeries and emergent operating time is the time used for emergency surgeries. A difference in the transfer price for emergent and elective could provide an economic signal to the user of the emergent time that there are made additional costs for the emergent time. Besides the additional costs of the operating rooms there are made extra costs at the anaesthesia, recovery and the CSA (Central Sterilization Department). In particular when an emergent surgery takes place in the weekend, holidays and nights, because in that case there should come personnel to the hospital especially for this emergent surgery. Therefore a difference between the transfer price between emergent and elective time should provide an economic signal for the user to make not unnecessarily use of the emergent operating time if a surgery can also be performed during the normal openings hours of the operating complex.
2. Informational function
A second purpose of transfer pricing is providing information about the performances of the managers. In the new decentralized structure the manager of the RVE of the primary process will get management information which includes the income and the costs of the RVE. Beforehand the manager of the RVE of the primary process was provided only with the costs of the RVE. The RVE generates income by executing DBCs and providing services for other parties. A DBC contains all activities performed by the hospital and the specialist.
of the primary process is not evaluated for the services used although they receive the income of the DBC for these services. By using a transfer price the costs of the supporting RVE operating rooms can be transferred to the user. Consequently, the performances of the manager of the RVE of the primary process can be better evaluated.
3. Move profits between divisions
A third purpose of transfer pricing is according to Merchant and Van der Stede (2007) to move profits between divisions this could be in the interest of the managers to minimizes the taxes. The Martini Hospital has several divisions, however they are located in one country and therefore this objective of transfer pricing is not applicable.
4.2 Contingency variables Martini Hospital
In this paragraph there will be explained how the three contingency factors (e.g. existence of a market price, asset specificity, and vertical integration) influences the choice of the transfer pricing method of the Martini Hospital. By using the developed conceptual model in chapter three there will be attempted to find a solution for the transfer pricing problem within the Martini Hospital
Vertical integration and diversification
Firstly the degree of vertical integration and diversification of the Martini Hospital are determined. The RVEs of the primary process and the units of the RVE operating rooms in the Martini Hospital are closely related to each other. In the case that the operating rooms are closed many of the treatments cannot be executed. Because the divisions are highly integrated with each other it is according to Eccles (1986) necessary to have a common strategy which is in the interest of the total organization. The divisions have a common strategy to provide good healthcare to their patients. According to the types of organizations described in chapter three the Martini Hospital can be described as a cooperative organization. For a cooperative organization the conceptual model recommended a cost-based transfer pricing method.
Asset specificity
