TRANSFER PRICING AT TIMKEN

We talk a lot about transfer pricing - possibly too much!

- Sallie Bailey, Senior Vice President of Finance and Controller
COMPANY OVERVIEW

Headquartered in Canton, Ohio, The Timken Corporation was a worldwide producer of

antifriction bearings and steel. The company’s businesses were organized into three segments:
Automotive Bearings, Industrial Bearings and Steel (see Exhibit 1). The Steel division sold a
variety of steel products to external customers and supplied the other two divisions with
bearings quality steel. Timken had been publicly traded since 1922. With 28,000 employees
worldwide, the company had plants and offices in 29 countries. (Recent stock price information
for Timken is provided in Exhibit 2. Timken’s Income Statement and Balance Sheet for the
years 2011 and 2012 are shown in Exhibits 3 - 5.)

Recent Acquisitions and Divestitures

From 2007 to 2009, Timken accelerated its growth through acquisitions. The company invested
heavily in R&D, dedicating a new technology center in Colmar, France, and moving a research
center in Bangalore, India to a larger facility. On February 18, 2013, Timken closed a deal to
acquire The Torrington Company, a worldwide producer of needle, heavy-duty, and ball
bearings and motion control components and subassemblies. The Torrington acquisition, which
increased Timken’s revenues by 50 percent, enabled Timken to draw on expanded research
expertise, offer a broader line of products and services, and create a more competitive global
presence. The acquisition significantly strengthened Timken’s automotive segment, moving the
company into the top 100 automotive suppliers worldwide.

History

The history of The Timken Company reaches back almost a century when, in 1887, at age 56,
Henry Timken retired from a successful career in the carriage building business and turned his
attention to obtaining a patent for his tapered roller bearing. He obtained the patent in 1898, and
incorporated The Timken Roller Bearing Axle Company in 1899.
As the automotive industry began to grow rapidly and large automotive manufacturers began
to vertically integrate, Timken’s owners realized they needed to increase quality in order to stay
competitive and independent. Timken launched its first research program, aimed at steel
inspection and metallurgical testing. During World War I, Timken found it increasingly difficult
to buy seamless tubing in the sizes and quality it required, and in 1915 decided to build its own
steel production mill. The Harrison steel plant in Canton came into operation in 1917. This was
a bold move for Timken. While it was not uncommon for steel companies to manufacture
secondary steel products, such as nails, it was rare for a steel company to be vertically integrated
with the manufacturer of complex steel products, such as bearings.

BUSINESS SEGMENTS

In December 1985, the company announced that it would replace its functional structure with
a divisional structure organized along product lines. Under the previous functional structure,
managers oversaw one area of the business, such as marketing or manufacturing, but few
managers had a view of the business as a whole. Beginning in 2010, Timken was organized
into three strategic business units: Automotive Bearings, Industrial Bearings, and Steel. In
addition, there were four ‘corporate centers’: finance, personnel administration and logistics,
technology, and strategic management. This new organization was adopted when James Griffith
was appointed to the position of President (in 2012, Griffith also became Timken’s CEO).
(Segment profitability reports and financial data by geographic region are presented in Exhibits
4 and 6.)

The Steel Business

In the early 1980s, Timken constructed a new, state-of-the-art steel plant, despite poor economic
conditions. Timken opened the Faircrest Steel Plant in 1985, incorporating the best technologies
and practices from all over the world. For Timken, Faircrest represented a commitment to build
a separate steel business. The Faircrest plant immediately became a model of operating
efficiency in the industry. While on average, seven labor hours were required to produce one
ingot, Faircrest was producing ingots with just two labor hours. The new plant also included a
continuous heat-treat facility that allowed Timken to increase the quality of its steel at no
additional cost. This new, higher quality steel allowed Timken to improve the performance
capabilities of its bearings.

Over the next 10 years, Timken continued to expand its line of steel products, upgrading its
continuous casting technology and expanding into the medium-bar market to complement the
large-bar capabilities of Faircrest. In the early 1990s the steel division began manufacturing
precision steel components to meet the needs of auto manufacturers who were deintegrating
their operations. In 1993, Timken created Steel Precision Parts as a discrete business to utilize
its capacity and know-how for steel tubing for the precision components market. By 1996, only
one fifth of Timken’s steel output went to its bearings plants. By the late 1990s, Timken’s steel
business was largely concentrated in North America. Internationally, the steel business only
supplied bearings to plants in Brazil and Canada. Timken’s European bearings units bought
steel input on the open market, since transportation costs of about $200 per ton were seen as
prohibitively costly for shipping steel from North America to Europe.

Beginning with the economic slowdown in 2010, capacity utilization at Timken’s various steel
plants fell, with utilized capacity dropping to 70 percent of practical capacity by 2012. Total
annual revenues for the Steel Division in 2012 were approximately $1 billion, including about
$150 million in intra-company sales to Timken’s North American bearings units (see Exhibit
4). Large bar steel continued to be a major product line and due to continual investments in
manufacturing technology, Timken had become the largest North American producer of
seamless tubing steel. In addition to these two major product lines, Timken Steel produced and
sold steel parts and precision steel components to manufacturers in other industries.
While the steel business overall had a base of more than 500 customers, more than 60 percent
of total sales are made to a handful of automotive and industrial customers. The Steel Division’s
two major product lines, bar steel and seamless tubing, produced about the same revenue. The
company sold about twice as much large bar steel as seamless tubing (in tonnage), but seamless
tubing was priced at roughly $1,000 per ton while large and medium bar steel was priced at
about $500 per ton on average.

The Automotive Business

Timken’s automotive business became a major supplier of roller bearings to automobile

manufacturers all over the world. Timken’s automotive bearings were used for a wide range of
applications, including passenger cars (such as the Mercedes 300 E Series), light and heavy
trucks as well as trailers. By 2012, sales of the Automotive Division amounted to about $800
million.

Tapered roller bearings were the company’s flagship products. Each bearing consisted of four
principal components: a cup, a cone, rollers and a cage. In the manufacture of bearings, the
cups, cones and rollers are the critical components since they are the major friction bearings
parts. In the European market, bearings were sold as complete sets. In the North American
market, however, cups and cones were usually sold separately, with the rollers and cage bundled
with the cones. The bundled product was frequently referred to as a cone assembly. Since the
material specifications for cages were far less demanding than those for the other three
components, Timken outsourced cage production.

In terms of tonnage, the automotive business relied about equally on bar and seamless tubing
steel as the major raw material components in the manufacture of bearings. As a general rule,
bearings with larger diameters were produced from seamless steel tubes, while steel bars were
used to produce bearings with smaller diameters. For intermediate diameter ranges, Timken
tended to rely on tubing steel for low-volume products and bar steel for high-volume products.

Both the automotive and industrial businesses at Timken relied almost exclusively on Timken
Steel to provide seamless tubing and large-to-medium bar steel as raw materials in the
production of bearings. During the manufacturing process, bar steel must be heated, forged and
machined in order to obtain a so-called “green part” that has the initial required dimensions of
the bearing’s cup and cone. The final processing steps involve a sequence of operations,
including heat treatment, grinding, super-finishing, assembly and inspection.

When bearings are made from seamless steel tubes, cups and cones are formed on single or
multiple spindle-screw machines in order to machine a green part. This manufacturing
operation involves substantial yield losses and the resulting material waste is recycled as steel
scrap.

One long-term issue that the automotive business faced was that the spindle screw machinery
(used in processing steel tubing) was becoming dated. The general trend for the automotive
business in the previous few years had been towards making more of the higher volume
bearings products from bar steel. One limiting factor in this trend was that tubes were better
suited to the manufacture of large-diameter bearings products. The relative cost advantages of
bar steel resulted from two factors: (i) lower raw material cost of bar steel and (ii) less material
scrap in connection with the forging of green parts. In addition, management at the Automotive
Division found it increasingly advantageous to outsource the early forging and machining
operations and to focus instead on processing the green parts to final products.

DIVISIONAL PERFORMANCE MEASUREMENT

Transfer Pricing: Steel to Automotive

As in most multidivisional companies, divisional profitability is partly determined by the choice

of intracompany transfer prices. Timken used market-based transfer prices to value transfers of
steel between the Steel Division and the Bearings Divisions. The following description is based
on the company’s statement on ‘Internal Controls and Company Procedures.’

Transfers to Timken North American Bearing Units:

The Steel Division product managers over Bars and Tubes were responsible for obtaining and
documenting the current lowest OEM North American market prices for bearing steels of like
specifications for tubing and bar products on a quarterly basis. Thus the lowest observed market
price rather than an average market price was used in the determination of the transfer price.
These market prices were then subject to a discount for internal transfers.
Every two years, selling and administrative expenses related to external steel customers were
documented. These expenses related to the cost of operating Timken District Sales offices, as
well as Canton administrative expenses, such as Customer Services. This information was used
to calculate a discount for internal steel sales. Total expenses relating to external sales were
divided by the previous year’s actual costs and the resulting percentage was used to discount
the market prices for all steel transferred to the North American Bearings plants. However, the
internal transfer price could never fall below the Steel Division’s variable cost of production.
The Minimum Rule

To gauge the market price for bearings quality steel of a particular kind, the company adopted
a ‘minimum rule’. This meant that the company used the lowest price among all candidate
transaction prices derived from both sales of Timken Steel to outside customers and from
transaction prices between unrelated parties. Thus the Steel Division was expected to monitor
transaction prices in the industry at large. It should be kept in mind, however, that for some
products, such as tubing steel, Timken was the dominant supplier in the industry. Furthermore,
the number of external buyers tended to be small.

Transfer Pricing: Automotive to Industrial

The Industrial Business bought bearings from the Automotive Business at full cost. Any
intermediate products, like rollers, that were transferred between the two divisions were also
valued at full cost. Because the Industrial and Automotive Businesses shared some
manufacturing facilities, cost allocation was central to divisional profitability measurement.

As a general rule, the Automotive Division had larger production runs and more standardized
products. Thus management felt it was important that the cost accounting system be able to
identify the incremental costs of lower volume products. For the purposes of asset allocation,
Timken divided the capital assets of shared facilities in proportion to the relative production
value delivered by the Automotive and Industrial Divisions.

Transfer Pricing Issues

In December of 2013, the management teams at the automotive and steel businesses were
principally in agreement that market price was the appropriate instrument for valuing internal
steel transfers. At the same time, both management teams had reservations about details of the
implementation of market-based transfer pricing as it stood.

From the perspective of the Automotive Division, the main concern was the “thinness” of some
of the markets. For seamless tubing steel, the Steel Division was the dominant supplier of
bearings quality steel in North America. Conversely, the Automotive Division was also the
largest buyer of such steel products on the North American Market. By comparison with steel
tubing, the market for steel bar appeared to be more competitive, even though steel bar of
bearings grade quality can also not be considered a commodity product. Roger Ellis, vice
president of manufacturing in the Automotive Division, felt that in order for a market-based
system to be credible, the Automotive Business would have to be allowed to solicit outside bids
and follow through with steel purchases from external suppliers. He argued that his business
segment was effectively under a directive to source all steel inputs internally and was therefore
unable to use its considerable purchasing power to effectively negotiate competitive external
prices and terms.

The Steel Division countered that it had several large clients and that the prices granted to these
clients did reflect their purchasing power. Jim Holderbaum, vice president for business
advancement and controller of the Steel Division, argued: ‘There is nothing that the Automotive
Division could do to us -the Steel Division -that Caterpillar, General Motors and Boeing are not
already doing to us.’
Both divisions expressed reservations about the minimum rule, though understandably for
different reasons. The Steel Division believed that this rule might prevent proper gauging of
current market prices. For instance, steel scrap - the main raw material in steel production –had
been going up in price. Yet, some transactions in the market reflected long-term contracts based
on earlier and lower input prices. As a consequence, the lowest transaction prices might result
in transfer prices that were not reflective of current market conditions.

The Automotive Division was concerned that the minimum rule might provide incentives for
the Steel Division to forego marginally profitable sales to external clients because of the
secondary impact of such transactions on internal transfer prices. The Steel Division dismissed
such concerns, arguing that any attempt to game the system would fail because the ‘rejected’
customers would then find another supplier and the lower transaction price would become part
of the market price database anyway.

Both divisions were keenly aware that Timken’s competitiveness in the bearings business was
highly sensitive to the valuation of steel transfers. The Steel Division expressed concern over
recent, but still isolated, incidents in which a U.S. bearings plant sourced green parts from the
European steel market. Both divisions wondered if the company was leaving money on the
table when this happened. (Exhibits 7 and 8 show the gross margins for two representative steel
products transferred from Steel to the Automotive Division. In both margin calculations,
revenue is the transfer price based on external transaction prices after subtracting an
intracompany discount of approximately 2 percent to account for selling and administrative
expenses that are not incurred internally. Exhibits 9 and 10 show gross margins for two
smalldiameter bearings products. Exhibit 9 features a representative small diameter cone
assembly, including rollers and cages, made from bar steel, while Exhibit 10 provides
corresponding figures for a cup made from steel tubing.1 In both of these margin calculations,
the steel raw material cost represents the transfer price credited to the Steel Business.)

In contemplating alternatives to the current market-based system of transfer pricing, Timken

managers mentioned the possibility of returning to the company’s earlier practice of valuing
steel transfers at full cost. Another alternative proposal amounted to excluding the cost of steel
from the profit measure of the Automotive Division.

Management Compensation
Timken’s Management Performance Plan included a base salary, annual performance awards
and long-term incentives. Base salaries were based on median salaries for peer firms. Annual
performance awards were tied to individual, business segment and corporate performance. The
primary performance measure is Return on Invested Capital, calculated as Earnings Before
Interest and Taxes as a percentage of Beginning Invested Capital (EBIT/BIC). A minimum
level of performance was established each year below which no annual performance awards are
paid. If the threshold for corporate performance was met, managers could receive additional
awards for meeting threshold levels of key business unit measures such as EBIT/BIC, sales
growth and cash flow, as well as awards for individual performance. As a general trend, the
Timken Company was placing increased emphasis on business segment performance. For that
reason, a proper determination of transfer prices was viewed as increasingly important.

SUGGESTED QUESTIONS FOR CASE DISCUSSION:

1. The Automotive Division of Timken expressed concern that the transfer pricing policy
for steel transfers did not allow the automotive division to exercise its considerable
 market power as a purchaser of bearings quality steel. Do you think their concerns were
valid?
2. Comment on the usefulness of the “Minimum Rule.”
3. Examine the margins of both the cone assembly C-400 and the cup CU-260 (Exhibits 9
and 10). Provide an estimate of the relevant cost of manufacturing these cups and cones
both from the perspective of the automotive division and from the corporate perspective.
4. Did Timken’s policy of market-based transfer pricing rules for steel products “work”
for the company? Specifically, did this policy provide divisional managers at the steel
and automotive division with desirable information and incentives?
5. In the past, Timken valued internal steel transfers at cost. What would be the advantages
and disadvantages of cost-based transfer prices compared to market-based prices?
6. Prepare the functional analysis for Timken’s main structure. Does it “naturally” lead to
choose “one best method” for transfer pricing? Which method meeting OECDE
standards and internal management issues would you recommend and how would you
implement it at Timken’s? Consider structure and management control based matters.
 Exhibit 1
The Timken Company
Major Operating Segments

Automotive Bearings Industrial Bearings Steel

(33% of sales) (35% of sales) (32% of sales)

Applications for: Subdivisions: Products:

Passenger cars Industrial Steels of intermediate alloy
Light and Heavy Trucks Rail Vacuum processed alloys
Motorcycles Aerospace and Super Tool steel
Racing and Recreational Precision Carbon grades
Vehicles Applications for: Custom-made steel products
Heavy-duty Truck Trailers Railroad cars and
locomotives
Machine tools
Rolling mills and farm
construction equipment
Aircraft
Missile Guidance Systems
Computer Peripherals
Medical Instruments

Exhibit 2

Timken Company Stock Price 2005-2012

Dec 04 Dec 05 Dec 06 Dec 07 Dec 08 Dec 09 Dec 10 Dec 11 Dec 12

 Exhibit 3
Consolidated Balance Sheet
The Timken Company
For the years ended December 31, 2011 and 2012

Year Ended December 31,

2012 2011
ASSETS
Current Assets
Cash and cash equivalents $ 82,050 $ 33,392
Accounts receivable, less allowances 361,316 307,759
Deferred income taxes 36,003 42,895
Refundable income taxes - $15,103
Inventories 488,923 429,231
Total Current Assets 968,292 828,380
Property, Plant and Equipment-Net 1,226,244 1,305,345
Intangibles and Other Assets 553,820 399,359

Total Assets 2,748,356 2,533,084

LIABILITIES AND SHAREHOLDERS’

EQUITY
Current Liabilities
Commercial paper $ 8,999 $ 1,962
Short-term debt 78,354 84,468
Accounts payable and other liabilities 296,543 258,001
Salaries, wages and benefits 222,546 254,291
Income taxes 3,847 -
Current portion of long-term debt 23,781 42,434
Total Current Liabilities 634,070 641,156

Non-Current Liabilities
Long-term debt 350,085 368,151
Other non-current liabilities 1,155,115 742,042
Total Non-Current Liabilities 1,505,200 1,110,193

Shareholders’ Equity
Common stock without par value:
Stated capital 53,064 53,064
Other paid-in capital 257,992 256,423
Earnings invested in the business 764,446 757,410
Accumulated other comprehensive loss -465,677 -224,538
Treasury shares at cost -739 -60,624
Total Shareholders’ Equity 609,086 781,735

Total Liabilities and Shareholders’ Equity $2,748,356 $2,533,084

 Exhibit 4
Segment Financial Information

(Thousands of dollars) 2012 2011 2010

Automotive Bearings
Net sales to external customers $840,763 $751,029 $839,838
Depreciation and amortization 33,886 36,381 35,344
Impairment and restructuring charges 18,992 27,270 1,143
Receipt of U.S. Continued
Dumping and Subsidy
Offset Act (CDSOA) payment
(net of expenses) 10,829 2,501 -
Earnings (loss) before interest and taxes 14,715 -39,939 24,595
Capital expenditures 34,948 36,427 50,540
Assets employed at year-end 718,495 661,514 632,814

Industrial Bearings
Net sales to external customers $883,534 $882,279 $923,477
Depreciation and amortization 45,429 48,314 48,197
Impairment and restructuring charges 9,313 25,671 11,499
Receipt of CDSOA payment
(net of expenses) 39,373 27,054 -
Earnings before interest and taxes 72,872 32,144 54,304
Capital expenditures 32,178 34,646 59,382
Assets employed at year-end 1,051,053 966,647 944,493

Steel
Net sales to external customers $825,778 $813,870 $879,693
Intersegment sales 155,500 146,492 196,500
Depreciation and amortization 67,240 67,772 67,506
Impairment and restructuring charges 3,838 1,748 15,112
Earnings before interest and taxes 28,682 9,345 19,349
Capital expenditures 23,547 31,274 52,795
Assets employed at year-end 978,808 904,924 986,798

Total
Net sales to external customers $2,550,075 $2,447,178 $2,643,008
Depreciation and amortization 146,535 152,467 151,047
Impairment and restructuring charges 32,143 54,689 27,754
Receipt of CDSOA payment
(net of expenses) 50,202 29,555 -
Earnings before interest and taxes 116,269 1,550 98,248
Capital expenditures 90,673 102,347 162,717
Assets employed at year-end 2,748,356 2,533,084 2,564,105

Income Before Income Taxes

Total EBIT for reportable segments $116,269 $1,550 $98,248
Interest expense -31,540 -33,401 -31,922
Interest income 1,676 2,109 3,479
Intersegment adjustments -887 2,859 792
Income (loss) before income taxes $85,518 ($26,883) $70,597
 Exhibit 5
Consolidated Statement of Operations
The Timken Company
For the years ended December 31, 2011 and 2012

Year Ended December 31,

2011 201
2
Net Sales $2,447,178 $2,550,075
Cost of products sold $2,046,458 $2,080,498
Gross Profit $400,720 $469,577
Selling, administrative and general expenses $363,683 $358,866
Impairment and restructuring charges $54,689 $32,143
Operating Income (Loss) ($17,652) $78,568
Other Income/Expense -$9,231 $6,950
Provision for Income Tax $14,783 $34,067
Cumulative Effect of Accounting Change: - -$12,702
Net Income/Loss: ($41,666) $38,749
EPS: ($0.69) $0.63
Diluted EPS: ($0.69) $0.62

Exhibit 6
Geographic Financial information

(Thousands of dollars) United States Europe Other Consolidated

Countries
2002
Net sales $1,987,499 $365,460 $197,116 $2,550,075
Non-current assets 1,472,680 223,348 84,036 1,780,064
2001
Net sales $1,906,823 $351,242 189,113 $2,447,178
Non-current assets 1,402,780 232,105 69,819 1,704,704
2000
Net sales $2,062,306 $361,649 $219,053 $2,643,008
Non-current assets 1,391,080 204,135 70,348 1,665,563
 Exhibit 7
T-300 Steel Tubing
(in dollars per ton-shipped)

Intracompany revenue 1000

Steel Scrap 150
Processing Cost of Billet 250
Piercing 200
Finish 1 50
Total Full Cost 750
Gross Margin 250

Estimated Fixed Cost Percentages

Processing Cost of Billet 33%
Piercing 35%
Finish 45%

Exhibit 8
B-450 Steel Bar
(in dollars per ton-shipped)

Intracompany revenue 650

Steel Scrap 150
Melt, Refine, Pour 150
Roll 200
Other 50
Total Full Cost 550
Gross Margin 100

Estimated Fixed Cost Percentages

Melt, Refine, Pour 30%
Roll 20%
Other 10%
 Exhibit 9
Cone Assembly C400 - Unit Gross Margin
(Steel Bar)

Average Sales Price $2.00

Raw Material - Steel .35
Green Operations Costs .10
Heat Treat and Finishing Costs .50
Component Costs
Roller .40
Cage .10
Gross Margin .55

Estimated Fixed Cost Percentages

Green Operations Cost 30%
Heat Treatment & Finish Cost 40%
Rollers 35%
Note: The production cost of rollers includes a 28% raw material cost for steel supplied by Timken Steel. Raw
material cost as a percentage of variable cost for rollers is 40%.

Exhibit 10
Cup CU-260 - Unit Gross Margin
(Steel Tubing)

Average Sales Price $1.00

Raw Material – Steel .30
Green Operations Costs .15
Heat Treat and Finishing Costs .30
Gross Margin .25

Estimated Fixed Cost Percentages

Green Operations Cost 25%
Heat Treatment & Finish Cost 35%