Offshore manufacturing contract design based on transfer price considering green tax: a bilevel programming approach

Abstract

The problem of designing offshore manufacturing contract resulting in optimal transfer price is troubling multinational companies over the past few years. This paper proposes designing offshore manufacturing contracts based on the transfer price in the form of bilevel programming problems after considering green tax. In these contract designs, a firm in a developed country sells a single product in its market. The same product is simultaneously being manufactured by another firm in a developing country with lower manufacturing cost. After anticipating the consumer demand, the seller places an order, based on which the manufacturer manufactures the ordered quantity, and offers a transfer price which in turn maximises its net profit after paying green tax to its government. While setting the transfer price, the manufacturer considers the manufacturing cost, the export duty payable to its government and the cost of shipping the product to the developed country. After buying the product from the manufacturer at the transfer price, the seller then sets the retail price which maximises its net profit after paying the import duty to its government; the retail price, however, must not be more than the maximum retail price applicable to the market. Thus, offshore manufacturing contract results in optimal after-tax profits for both the firms. An experimental study has been carried out to discuss the practical aspects of the results developed, where a US firm is offshoring its manufacturing activity to a Chinese firm in order to draw maximum profit.

Keywords:

• outsourcing
• offshore manufacturing
• supply contract
• transfer price
• green tax
• bilevel programming

Acknowledgements

The authors wish to express their sincere thanks to the anonymous reviewers and the AE for their valuable remarks and helpful suggestions, which have significantly improved the quality of the paper.

Notes

1. UNFCCC divides countries into three main groups according to differing commitments (source: http://newsroom.unfccc.int/):

Annexe I. Parties include the industrialised countries that were members of the OECD (Organisation for Economic Co-operation and Development) in 1992, plus countries with economies in transition (the EIT Parties), including the Russian Federation, the Baltic States and several Central and Eastern European States.

Annexe II. Parties consist of the OECD members of Annexe I but not the EIT Parties. They are required to provide financial resources to enable developing countries to undertake emissions reduction activities under the Convention and to help them adapt to adverse effects of climate change.

Non-Annexe I. Parties are mostly developing countries.

2. The Stackelberg game is a strategic game in economics in which the leader firm moves first, and then the follower firms move sequentially. It is named after the German economist Heinrich Freiherr von Stackelberg who published Market Structure and Equilibrium (Marktform und Gleichgewicht) in 1934 which described the model.

3. Cap and trade is the most environmentally and economically sensible approach to control greenhouse gas emissions, the primary driver of global warming. The ‘cap’ sets a limit on emissions, which is lowered over time to reduce the amount of pollutants released into the atmosphere. The ‘trade’ creates a market for carbon allowances, helping companies innovate in order to meet, or come in under, their allocated limit. The less they emit, the less they pay, so it is in their economic incentive to pollute less.

4. We have no evidence so far that green tax will be applied on net profit. It could have been levied on the total revenue like export duty and sales tax, but in the case of break-even the taxation will result in a loss and hence will discourage the firm in doing business. Levying a green tax on the total manufacturing cost as the penalty of natural resource consumption is going to discourage the manufacturer and hence the supply and consequently the labour welfare will be low. Hence, we have assumed the green tax to be levied on the net profit (like income tax which is charged on EBIT = total revenue – total costs and expenses) so that in the case of break-even no tax is to be paid. We are going to impose the constraints of non-negative profits. So, taxation in the event of loss is out of scope of the problem.

5. In case of offshoring, the product gets transshipped from the manufacturer country to the seller country, and hence which country should pay the green tax is a topic of debate. Practically the manufacturer country should pay the green tax to its government as the manufacturing process consumes resources and pollutes the environment of that country where the manufacturing takes place, and hence our assumption.

6. Termed as the ‘minimum reservation profit’ in the offshoring literature.

7. The coupling constraint (6) becomes the seller’s constraint in this case as the seller is constrained to take the ultimate decision on v for the given u.

8. In this case the manufacturer is not free to set any u, she is constrained to take ultimate decision on u for the given v so that the seller gets the motivation for offshoring by achieving at least minimum reservation profit. Hence, in this case, the coupling constraint (6) becomes the manufacturer's constraint.