How Treasury Transfer Pricing Methods Can Help Transform a Cost Centre into a Profit Centre
Oleh Kurinnyi, global treasury and operations specialist, explores potential advantages of the transfer pricing mechanism in both corporate and bank treasury.
Every company undergoing the long transformation from start-up to complex global organisation must at various stages re-evaluate the relevance and effectiveness of its different departments, branches or offices, and even individual employees. It must also work towards building an appropriate motivation system capable meeting new challenges, and grasping every opportunity.
When assessing the corporate evolution from lowly caterpillar to beautiful butterfly, often the first approach is to use the amount of reported revenue or income generated by each department or employee as the sole criterion of success.
This works well when comparing the efficacy of sales departments or individual traders in different regional centres of the organisation. At a very basic level, if the EMEA team’s sales volume in the reporting quarter was €10m, and the APAC team’s was €20m, it is immediately apparent that the APAC team was more successful. If the company’s profit reached the level at which a quarterly bonus is provided, this bonus may be distributed between these teams in a ratio of 1:2. At the corporate buffet in honour of the successful closing of the quarter, the APAC team will be allowed to eat twice as many cakes as its EMEA colleagues.
Of course, an enquiring mind will immediately notice that, in this example, it is more appropriate to use relative indicators rather than absolute revenue values. For example, the ratio of revenue to the operating costs of each team, or the average revenue per trader. But there is yet another consideration.
Levelling the playing field
The business process of any trading or service company can be simplified between the work of the front office, and those of its support services, otherwise known as the back office.
The front office usually consists of sales departments that negotiate and make deals with clients or other market participants. They directly influence the amount of revenue and income received. For the company, these departments are a priori profit centres. As such, they receive bonuses and intangible incentives. They are often seen as the breadwinners, or even the company superheroes.
Meanwhile, the back office comprises a variety of services that provide the front office with market information, legal support, IT services, financial operations, recruitment, training and so on. To ensure the operation of these services, the company incurs a range of expenses such as salaries, office rent, the purchase of computer and office equipment, software and cloud traffic, taxes, government and utility services, logistics, and security for the company’s offices and products.
At first glance, support services may be seen as a financial burden on the company. Senior management may barely tolerate them, often seeking to minimise their costs, including labour. KPIs for the back office are often focused on minimising operating costs, and reducing operational errors. There will be no talk of bonuses: they are simply cost centres.
As an approach to evaluating back-office work it is unfair and often counterproductive. But this inequity can be changed for the benefit of all – including the front office.
Motivating profit
Here’s a quick reality check.
First, without support services, the front office would not be able to achieve the positive results that ensure revenue and income from sales for the company. The overall financial result must be seen as a contribution from every employee.
Second, if back-office employees have no incentive to put extra effort into their work and increase productivity, often they won’t; they are human after all. This has consequences. If a highly motivated front office increases sales by 50%, an unmotivated back office can become a bottleneck in the business process. This may force extended order fulfilment times, or require the hiring of additional support staff. Ultimately, the company’s development and reputation may be at risk.
To stimulate the back office, it is necessary to make it a profit centre on a par with the front office.
Imagine the structure of a company as a performance engine, with many interdependent components. For that engine to run at peak, each component is of equal value, and must be well-crafted and fulfil its task exactly as required. It doesn’t matter how much power is generated, if one or more components are not performing well, that engine runs poorly. And, under pressure, may even fail.
In a business, cash flows can be represented as the power of the engine, derived from the effort of interdependent back- and front-office business functions. For the front office to achieve its profits, back-office services must be provided. In other words, front and back offices must work as a unit.
With a change in mindset, back-office services can be delivered to front-office functions at an agreed internal price per function. The income received enables each service to fulfil its role, while effectively collecting on its share of total company income. After allocating costs to the front-office business units for services rendered, the profitability of each back-office department can easily be determined.
In this model, the back office now becomes a service centre for profit. Its employees will be motivated to work harder and develop, which ultimately contributes to the growth of sales and market capitalisation of the company, and the firm’s reputation is maintained or boosted. This is the essence of the service-based model of the transfer pricing system.
Share the work, share the wealth
The co-ordination of the company’s internal virtual cash flows is usually handled by corporate treasury, in conjunction with the controller’s department. The prices for services provided to each other by different departments of the company are called internal transfer prices. They are selected at the level of average external market prices for services provided by companies that specialise in the relevant types of activities (such as legal, financial, IT support, logistics, and security) – these prices mark the so-called ‘arm’s-length principle’ of transfer pricing.
Based on the results of the reporting period, treasury calculates the profit of each back-office department, and thus its share in the company’s total profit. When the company as a whole achieves its KPIs, not only does the front office receive a bonus, but so too does the back office.
In addition, the transfer pricing system encourages company management to optimise the costs of various services. If any internal service has not been profitable for a long time, it may be worth considering outsourcing this type of support. Typically, external contractors cover legal, logistics, and recruitment, with financial services contracted for calculating employee salaries and optimising business processes.
Often, to increase control, minimise costs and hedge operational risks, regional back offices are replaced by centralised service centres (while front offices maintain a presence in sales regions). Ireland, with its highly skilled English-speaking workforce and favourable tax system, has become a popular location for the headquarters, financial centres and service centres of many global banks and technology companies.
If it works for banks…
The concept of funds transfer pricing (FTP) is popular in the banking sector. Along with virtual payment by front offices for back-office services, banks face the task of internal funding of credits from the treasury, as well as mirror purchases by the treasury of resources from departments that attract customer funds in deposits and on capital markets.
In banking practice, transfer pricing is a mechanism for the internal redistribution of income and expenses between divisions. It enables the interest margin of business divisions to be separated from market risks (interest rate and liquidity risk) managed by the treasury. For internal trading, the treasury constructs a yield curve showing the change in base rates depending on the maturity of the funding.
The Euro Short-Term Rate (€STR) is used as the base rate for calculating yield curves and determining transfer prices for internal divisions for transactions in euros. The €STR is the average rate for overnight unsecured loans in the euro area wholesale money market, calculated by the European Central Bank (ECB).
The €STR has replaced the former Euro OverNight Index Average (EONIA) rate and has become the preferred replacement for Euro Interbank Offered Rate (EURIBOR) as a risk-free rate. Although EURIBOR continues to be published and widely used in retail products (such as mortgages), the €STR is the standard for internal bank pricing and large transactions in the wholesale market.
The SOFR is used as the base rate for calculating yield curves and determining transfer prices for internal divisions for transactions in US dollars. SOFR is the rate for overnight repo transactions secured by US Treasury bonds. It is considered a risk-free interest rate (RFR). SOFR replaced the previous LIBOR USD rate, which ceased to be published for most maturities in mid-2023. In 2026, the use of LIBOR in new contracts will be extremely limited or prohibited.
As a result of these changes, the use of transfer pricing in banks enables both credit departments and deposit departments to be assessed as profit centres. This is despite the fact that, from a formal point of view, the former generates interest income for the bank and the latter generates interest expenses.
In assuming this model, it brings a degree of fairness to the assessment of each department’s contribution to the final result. In turn, this allows for the development of an equitable employee motivation system. Overall, it contributes to the sustainable development of the business.
A corporate treasurer admiring the profitability of their banks may be encouraged to enquire how a transfer pricing model may suit their own circumstances.
