The Japanese Market for Xbox 360 with the Main Focus on Strategic Transfer Pricing Techniques - Research Paper Example

Theory of Transfer Pricing in relation to competitiveness, management, minimisation, avoidance and internal concerns and critical evaluation of the pricing strategy (market or cost) of the Xbox 360 Name: Roll No: Class: Subject: Teacher: Date: 29th March 2009 University Discuss the theory of Transfer Pricing in relation to competitiveness, management, minimisation, avoidance and internal concerns. Use the theory as basis for a critical evaluation of the pricing strategy (market or cost) of the Xbox 360. Introduction Transfer pricing is typically concerned with inter-country level transactions on sales of goods and services, patenting and licensing, lending and borrowing of money, payment of interest and so on taking place among branches or between the parent company and subsidiaries of a multinational organization. An obvious first outcome of this practice is the avoidance of market mechanisms such as those, which fix prices through free demand and supply forces. Optimal transfer pricing techniques are adopted by MNCs to maximize profits within the organization through tax liability avoidance (Keegan and Green 2005). The strategic imperatives behind transfer pricing efforts include a desire to have a competitive edge over rivals, minimize costs or maximize revenue, maximize strategic management-related gains such as x-efficiency and above all establishing market leader status. Any MNC would introduce its product into a foreign market by using transfer pricing as a very attractive pricing strategy within the organization itself. The first and foremost strategic initiative is to arrive at an overall estimate of the organization’s cost structure and its composition such as the amount of fixed cost, variable cost, average cost and marginal cost. Then the firm would look at its revenue flow estimates such as the total revenue, average revenue and marginal revenue. An MNC would adopt optimal transfer pricing strategy and its variants to achieve organizational goals and corporate objectives as an MNC across the world (Elliot and Emmanuel 2000). This paper would examine in detail the Japanese market for Xbox 360 with the main focus on strategic transfer pricing techniques that would be adopted by Microsoft in Japan to achieve its main organizational aims. Thus, its remit would include such international marketing concepts as strategic market/customer/product/competitor orientation, and tactics like the principle of maximum product differentiation. 1. Analysis 1.1. Theoretical overview It is not unusual for MNCs to apply transfer pricing in a variety of international business contexts. Video game console market in the world has not only been noticed to possess some peculiar characteristics but also it has intrinsically developed unique trend of extrapolation in conformance with cross self-entertainment specificities across a series of broader market segments. Transfer pricing is adopted by MNCs under diverse and complex circumstances in a variety of country-specific contexts. Such adoption can be categorized as optimal transfer pricing meant for maximizing profits while tax avoidance is essentially ingrained in it. Transfer pricing practices among MNCs are basically determined by a desire to increase profitability of each individual branch or subsidiary thus effectively foreclosing negative impacts of economic, regulatory and fiscal environments at an international level (Jovanovic 2008). As much as double taxation is sought to be avoided by MNCs, there is an ever-increasing countervailing desire to avoid taxes at arm’s length. International subsidiaries of MNCs are managed and run as both separate units and integral units simultaneously depending on the purpose for which such categorization is carried out by the management. It is none so well considered to be imperative to classify operations of subsidiaries on any other feasible ground than on the profitability and strategic competitive orientation parameters (Doole and Lowe 2007). Indeed these two variables entail a number of other accidental and incidental outcomes concerning overall organizational goals such as international market share, the share price at critical stock exchanges and facilitation of rational international Human Resource Management (HRM) practices. 1.2. The launching of Xbox 360 in Japan: A market analysis The following data in the Japanese economy would be used to launch Xbox in the Japanese market. In a period of 8 years Japan’s GDP per capita at Purchasing Power Parity (PPP) has increased by $1400. Naturally, the impact of this rise could be seen in an increase in expenditure on entertainment. Video game consoles have the biggest attraction for the Japanese. Table 1: Japan’s GDP per capita at PPP in US$ from 2000 to 2008 Year GDP - per capita (PPP) (US$) 2000 23400 2001 24900 2002 28000 2003 28000 2004 28200 2005 29400 2006 31600 2007 33100 2008 33800 Source: www.indexmundi.com. The following graph illustrates the trend in Japan’s GDP per capita growth in approximately a decade. Based on the data in the above table the following graph illustrates how Japanese citizens would have been able to spend a greater percentage of income on entertainment because naturally as the real income rises people tend to buy luxuries including games. Figure 1: Japan’s GDP per capita growth trend between 1999 and 2009 Table 2: Japan’s GDP real growth rate between 2003 and 2008 Year GDP - real growth rate Rank Percent Change Date of Information 2003 -.30 % 188   2002 est. 2004 2.70 % 123 -1,000.00 % 2003 est. 2005 2.90 % 143 7.41 % 2004 est. 2006 2.60 % 157 -10.34 % 2005 est. 2007 2.20 % 182 -15.38 % 2006 est. 2008 2.00 % 188 -9.09 % 2007 est. www.indexmundi.com. As the above table illustrates Japan’s real GDP increased only in 2005 by 7.41% while in other years here it was negative. A negative GDP in pure monetary terms means very little unlike GDP per capita at PPP. Yet the launching of Xbox 2005 could not have been propitious. As the subsequent developments showed, it was very difficult period for the product. However, in terms of transfer pricing gains Microsoft Japan achieved quite a lot by way of transferring costs to subsidiaries in full. 1.3. Analytical presentation According to a recently published Global Transfer Pricing Survey 2007 – 2008 by Ernst & Young (www.ey.com), the practice of transfer pricing is fundamentally a very big problem when it comes to financial reporting, especially with regard to double taxation. The individual firm’s concern to avoid declaring profits on the ground that its other subsidiary or the parent company has already declared it and therefore there is no need for it under the international law to declare profits for taxation purposes is even more compelling when different territorial jurisdictions tend to have their own tax systems (Abdallah 2004). Above all, transfer pricing might help the subsidiary or the parent company to conceal its profits by deliberately under-invoicing its sales to the other. 1.3.1. Industry analysis of game console market The industry analysis of the game console market takes this dilemma of the MNC into consideration with particular emphasis on the theoretical and practical significance against the backdrop of cost and revenue structures of the firm. The following diagram illustrates this outcome based on a hypothetical approximation of production costs and sales revenues of the average firm practicing transfer pricing thus invariably trying to maximize profit or minimize costs. The average MNC makes every effort to maintain a monopoly situation for its product by equating Marginal Cost (MC) to Marginal Revenue (MR). The point of intersection between the MC curve and the MR curve produces the profit maximizing point for the firm. The average firm in the industry has no desire to increase its output beyond this point if profit remains higher despite market not being saturated. Microsoft in the first three months after introducing Xbox 360 into the Japanese market just managed to capture no more than 5% of the Japanese game console market while Sony had 80%. The scenario has now evolved into a totally different one though. As recently as February 2009, Microsoft outsold both Nintendo’s Wii and Sony’s PS3 (www.edge-online.com). As the diagram below shows when the firm is involved in inside trade alone and no external selling at all, there is the probability that MC and MR can be separated NMC and NMR to give a clearer picture of outcomes. The most efficient output level could be to the right where Average Cost curve intersects the Average Revenue curve. Assuming that the MNC is able to sell the product in competitive market segments where MR = Price, profit margins would shrink to such an extent that despite meeting the profit maximizing rule, viz. MC = MR, Price at P2 (T) would curtail the firm’s ability to increase profit volumes (Craig and Douglas 2005). 1.3.2. The evolution of transfer pricing in the game console environment Competitiveness The above theoretical postulates have a truly versatile empirical resonance in the game console market in Japan. Right now Microsoft Japan’s sales are picking up much faster due to two factors. In the first instance, Japan is a highly competitive market for game consoles and therefore Microsoft’s global strategic product/market orientation plans are probably producing the intended results (Tang 1993). Secondly, its cost and revenue structure is much akin to the competitive firm’s cost and revenue structure. According to profit declarations for the successive quarters of the financial year 2008, Microsoft did not make huge profits on its game console until the last quarter of 2008 ending in September. However, the Japanese market has turned around and Xbox is driving the sales far ahead of the rest. Once market leader PS2 (and now PS3) is nowhere near the sight. 25,334 units were sold after the release of Square Enix’s Star Ocean 4: The Last Hope by the end of February 2009 in Japan. Comparative sales figures of the nearest rivals Wii and PS3 are far behind. By horizontally summing up the internal market sales and the external market sales as shown on the above diagrams (first two), the aggregate demand figure is obtained (the third diagram). External market imperfections allow the MNC (or its subsidiary as in Japan) to make above normal profits as shown by the higher sale price of P (t). The MNC achieves its profit maximizing or/and revenue maximizing goals by selling the internal market’s amount of Q (f) plus the external market amount of Q (t). Thus, the aggregate sales ought to bring about a considerable amount of profit to the firm. Nonetheless, the strategy of bifurcating the market into a domestic segment and an external segment is altogether prone to other imperfections (Onkvisit 2004). In the first instance in the external market, i.e. Japan, the level of competition is too high though market imperfections exist due to a very high degree of brand loyalty. As much as it’s difficult to overcome existing brand loyalties of consumers in a market like that of Japan, it’s almost impossible to strategically leverage market outcomes based on pure competition (See Appendix). Management The last point focuses this analysis on the management-centric perspectives of the firm. Transfer pricing practices are resorted to by MNCs as an essentially strategic initiative to achieve organizational goals. For example, market share and the share price of the Microsoft’s Entertainment Arm in the world suddenly started to look up during the post February 2009 period as a result of the rise in sales revenue and profits in the period under review. Internal management structures and practices at Microsoft Japan underwent such drastic change (Graser and Stanley 2005). This is essentially the practice at every MNC depending on the availability of resources and the decision making freedom to the local unit’s head. Minimisation However, there is a concurrent principle of taxation that goes parallel to this argument of MNCs’ seeking to avoid paying taxes at both ends. Assuming that one or a combination of the arm’s length taxation policies is adopted neither the host government nor the MNC would lose out on the transparency front. However, cost minimization or profit maximization efforts of the MNC at various levels in various market segments cannot be ruled out as non-extant. Such efforts exist as shown by the following three parallel diagrams (Czinkota and Ronkainen 1994). While the demand curves show different possibilities under transfer pricing strategy of the firm, there is little else by way of differences to notice in the behaviour of the firm practicing transfer pricing from one, which does not. Avoidance What matters are the NMC and NMR of the individual firm and not the conglomerate or the group? NMR is defined as the “net marginal revenue after distribution costs have been deducted”. For instance let’s assume that Xbox 360’s unit production cost at the US manufacturing facility is estimated at $200 (the standard unit with a 60 GB hard drive) while the distribution cost of Microsoft Japan in Tokyo amounts to $50. Leaving a profit margin of $70 per unit, the selling price ought to be $320 in Japan. Now the dilemma faced by Microsoft Japan is that of avoiding a tax on its profits because already the parent company in the US has paid a tax on profits to the US government. If and when Microsoft Japan pays a tax, let us assume $35 per unit, the profit margin would be halved. This is a very common hypothetical scenario. The following Bar chart illustrates how the market sales of game consoles had been rising in Japan until 2098. After that as a general trend, sales have dropped in all three markets. Transfer pricing does not help much when markets fall due to a general economic downturn. Figure 3: Market size of game console and PC software in Japan, Europe and North America Source: www.ir.capcom.co.jp. Internal Concerns For all purposes of costing and budgeting at any subsidiary the parent company in ought to assume responsibility only to the extent of value adding services other than the original production cost transfer to the local unit. For example advertising and promotion costs in the external market have to be borne by the subsidiary to the extent such activities have a local significance. Thus, the internal concerns of the MNC have to be addressed with a management or leadership style that goes parallel to the independent decision making ability of the senior managers at the subsidiary. Costs A partial improvement in the firm’s strategic operational environment caused by transfer pricing techniques could be seen in respect to Microsoft Japan too. In the first instance, Xbox was sold in Japan as an exclusive independent operation. Microsoft adopted a strategic cost transferring method to allow the Japanese unit to face all its financial obligations within Japan as an exclusive burden of its own. This strategy coupled with a change in attitude towards competition helped it to adopt transfer pricing practices basically by virtue of technology design, planning and transfer between the parent company and the subsidiary in Japan (Dahi 2004). Thus, the relationship led to effective cost transferring accompanied by transfer pricing. That virtually helped both the parent company and the subsidiary. This is applicable to any firm in general. Conclusion Transfer pricing as part and parcel of international marketing practices, has been critically looked at for the sole reason that it has generated so much of controversy on the aftermath of recent disclosures about the inner workings of MNCs in cross-border transactions. Often MNCs seek to avoid double taxation while at the same time seeking to under-invoice sales from one un it to the other so that profits one unit can be concealed or downgraded (Markham 2005). Despite the firm’s ability to sell its final product in external imperfect markets at a fairly lower price still covering its MC, the firm does not do so just because its profit maximizing or conversely cost minimizing strategy bears fruition only when market segmentation leads to profit/revenue differentials that enable it to achieve organizational goals. Price cutting exercises sometimes pay off handsome rewards by way of strategically shifting the market-oriented competition towards product orientation as in the case of the Japanese game console market/industry. REFERENCES Abdallah, W.M 2004, Critical Concerns in Transfer Pricing and Practice, Praeger Publishers, Connecticut. Craig, C.S. and Douglas, S.P 2005, International Marketing Research, 3rd Edition, John Wiley & Sons Ltd, West Sussex. Czinkota, M.R. and Ronkainen, L.A 1994, International Marketing Strategy: Environmental Assessment and Entry Strategies, University of California, California. Dahi, C.A 2004, International Energy Markets: Understanding Pricing, Policies Profits, Pennwell Books, Tulsa. Doole, I. and Lowe, R 2007, International Marketing Strategy: Analysis, Development and Implementation, Cengage Learning EMEA, London. Graser, M. and Stanley, T.L 2005, Key function on Xbox 360: marketing; Microsoft paints world of sponsorships, sports, engagement, community (News)(marketing strategies of Microsoft Corp. for launching Xbox 360), from www.resources.bnet.com. Jovanovic, M 2008, Evolutionary Economic Geography: Location of Production and the European Union (Routledge Studies in Global Competition), Routledge, Oxford Keegan, W. and Green, M 2005, Global Marketing, Prentice Hall, New York. Markham, M 2005, Transfer Pricing of Intangibles, Kluwer Law International, London. Onkvisit, S 2004, International Marketing: Analysis and Strategy, 4th Edition, Routledge, New York. Precision under Pressure: Global Transfer Pricing Survey 2007-2008, Ernst & Young from www.ey.com Tang, R.Y.W 1993, Transfer Pricing in the 1990s: Tax Management Perspectives, Quorum Books, Connecticut. Wlliot, J. and Emmanuel, C 2000, International Transfer Pricing: A Survey of Cross-Border Transactions, CIMA Publishing, London. www.edge-online.com. APPENDIX Growth in repeat sales, particularly for & Monster Hunter Freedom 2G" (Unit: 000 copies)   Title Region Date Plan Total PSP Monster Hunter Freedom 2G (Repeat) Japan Mar. 27 1,600 1,600 Xbox360 PS3 Lost Planet Colonies Japan May. 29 30 400 USA May. 27 120 Europe Jun. 1 250 Wii Okami USA Apr. 15 210 300 Europe Apr. 15 Million yen)   2006/9 2007/9 2008/9 Difference Net Sales 15,735 16,323 16,486 163 Operating Margin 14.4% 15.1% 22.1% 7.0% Thousand units) Titles 32 50 50 0 Japan 1,700 2,900 3,000 100 North America 2,000 1,700 1,100 -600 Europe 850 1,200 800 -400 Asia 150 100 200 100 Total 4,700 5,900 5,100 -800 Composition) (Thousand units) Distribution Titles 620 960 540 -420 Old Titles 1,500 2,100 3,500 1,400 "Planning launches of several major titles Raised planned sales for Resident Evil 5" Unit: 000 copies)   Title Region Date Plan Xbox360 PS3 Resident Evil 5 Japan Mar. 5 3,250 USA Mar. 13 Europe Xbox360 PS3 PC Street Fighter IV Japan Winter 2009 1,700 USA Europe Xbox360 PS3 PC Bionic Commando Japan Early 2009 1,500 USA Europe Wii Dead Rising Chop Till You Drop Japan Feb. 2009 500 USA Europe Home Video Games Business for FY 2008 ending March 31, 2008 Raised fiscal year sales plan due to increase in planned sales volume in second half (Million yen)   2007/3 2008/3 2009/3 Plan Difference Net Sales 43,813 51,679 64,300 12,621 Operating Margin 18.4% 22.5% 26.9% 4.4% Thousand units) Titles 90 106 89 -17 Japan 5,200 7,100 6,000 -1,100 North America 4,300 4,700 5,900 1,200 Europe 2,400 3,450 6,900 3,450 Asia 300 350 400 50 Total 12,200 15,600 19,200 3,600 Composition) (Thousand units) Distribution Titles 1,200 1,650 1,400 -250 Old Titles 3,100 4,550 3,750 -800 Source: www.ir.capcom.co.jp Read More