W. BentzA&MIS 5251 Agenda - Session 20 Continue our discussion of transfer pricing Talk about review session Talk about final

W. BentzA&MIS 5252 Divisions Divisions are investment centers whose managers have the broad decision-making authority associated with decentralized management systems Divisions may have a variety of legal forms (corporations, unincorporated, etc.)

W. BentzA&MIS 5253 Divisions Divisions vary greatly in size Financial controls dominate since the decision-making is decentralized

W. BentzA&MIS 5254 Transfer Pricing A transfer price is the price at which a product or service is transferred from one entity to another entity within the same firm. Typically when products are moved from one cost center to another within a manufacturing system, the transfer price is the cumulative cost of the product to date.

W. BentzA&MIS 5255 Pricing Goods and Services Large, decentralized organizations simulate market economies by allowing internal (transfer) prices to guide intra-firm economic activity. Ideally, managers would be free to price transfers of goods and services at a mutually agreed upon price, as in a market economy. Divisions would buy from the best sources and sell to maximize their own profitability.

W. BentzA&MIS 5256 Decentralization Purposes To decentralize authority and responsibility to those managers closest to the business. To train future executives To provide managerial incentives to operating executives To isolate economic efficiency by responsible entity

W. BentzA&MIS 5257 Decentralization Purposes Distribute overall profitability among contributing entities Distribute overall profitability among taxing entities, usually countries

W. BentzA&MIS 5258 Transfer Pricing Methods Transfer pricing methods that include a profit element include: –Marginal cost (economic theory) –Administered prices –Cost-plus prices –Negotiated prices –Market prices

W. BentzA&MIS 5259 Transfer Price = Internal Price Primary or inter- mediate producer Intermediate Producer or Distributor External Customer Transfer price Final price Corporate Entity

W. BentzA&MIS Note!! The selling division’s “price” is the buying division’s “cost” for divisional performance measurement purposes. Production decisions are differential analysis decisions in a multi-entity context. Resources may be constrained.

W. BentzA&MIS Three Perspectives In making production decisions in a decentralized management system, one must consider three different perspectives: The total firm The selling division The purchasing division

W. BentzA&MIS The Texas Two-Step First, the financial analyst must decide if transfers should take place to enhance the profitability of the overall firm. The objective in this context is to maximize periodic income from operations.

W. BentzA&MIS The Other Step Second, if transfers are to the benefit of the overall firm, then the pricing system should encourage such transfers. Conversely, if transfers are not in the best interests of the overall firm, then the pricing system should discourage transfers. The pricing system should provide an incentive to “do the right thing.”

W. BentzA&MIS Artic Delights Artic delights sells ice cream to franchisees for $1.75 per gallon. An external supplier is willing to supply comparable ice cream for $1.50 per gallon.

W. BentzA&MIS Artic Delights TotalPer Unit Sales$17,500 $ 1.75 Variable cost 10, Contribution margin$ 7,500 $.75 Machine & rental cost 6, Income from operations$ 1,500 $.15

W. BentzA&MIS Sandwich Stands We do not know the ultimate sales price to final customers, but price increases are not at issue. 1.Sandwich stands should buy from Artic Delights so long as the purchase price paid by the stand exceeds the variable cost of producing ice cream.

W. BentzA&MIS Artic Delights 2.Artic delights should produce so long as the purchase price is above variable cost of $1 per gallon. 3.If the stands could buy ice cream for $1.50 per gallon, then Artic Delights will have to drop its price.

W. BentzA&MIS Artic Delights 4.How does the transfer price affect the profitability of (a) Artic Delights excluding the stands, (b) each Sandwich stand, and (c) Artic Delights and its sandwich stands combined. (a) The higher the transfer price, the higher the profits of Artic Delights, excluding the stands. The lower the price, the lower the income from operations.

W. BentzA&MIS Artic Delights 4 (b).The higher the transfer price, the lower the income of each stand, and the lower the compensation of each manager. The lower the transfer price, the higher the income of each stand and the higher the compensation of each manager.

W. BentzA&MIS Artic Delights 4 (c). When the stands are included with the results of Artic Delights, profitability is reduced to the extent that transfer prices are lower and the managers earn a higher return. This is a real problem in terms of balancing compensation and incentives.

W. BentzA&MIS EFG Company Division S (Supplying) makes: Subassemblies Price$260 Variable cost 200 Contribution margin$ 60 (1) Widgets Price$150 Variable cost 125 Contribution margin$ 25 (4)

W. BentzA&MIS EFG Company Division P (Purchasing) makes: Product B Price$400 Variable cost* 160 Contribution margin$240 (2-$40) Gadgets Price$180 Variable cost 150 Contribution margin$ 30 (3)

W. BentzA&MIS EFG Company Case A: Maximum external sales: Division S - 1,600 subassemblies (capacity = 2,000 units) Division P Gadgets (capacity = 1,000 units)

W. BentzA&MIS EFG Company Division S [Capacity: 2,000 units] Division P [Capacity: 1,000 units] Product B Gadgets Widgets Subassemblies External Customers Subassemblies

W. BentzA&MIS EFG - Case A Sales constraints or projections: 600 Gadgets to outside customers 1,600 Subassemblies outside 200 Widgets to outside customers

W. BentzA&MIS EFG - Case A Division S Production Plan: 1,600 subassemblies for external sale 400 subassemblies for Div. P Division P Production Plan: 400 units of Product B 500 Gadgets 100 units of idle capacity

W. BentzA&MIS EFG - Case B Case B: Maximum external sales: Division S - 1,600 subassemblies widgets (capacity = 2,000 units) Division P Gadgets (capacity = 1,000 units)

W. BentzA&MIS EFG - Case B Division S Production Plan: 1,600 subassemblies for external sale 400 subassemblies to Div. P Division P Production Plan: 400 units of Product B 600 Gadgets

W. BentzA&MIS EFG - Case C Case C: Maximum external sales: Division S - 1,500 subassemblies widgets subs to $240 (capacity = 2,000 units)

W. BentzA&MIS EFG - Case C (Div. S) Division S Production Plan: 1,500 subassemblies for external sale 500 subassemblies for Div. P 0 Widgets

W. BentzA&MIS EFG - Case D (Div. S) Case D: Maximum external sales: Division S - 1,500 subassemblies widgets subs to P for $220 (capacity = 2,000 units)

W. BentzA&MIS EFG Case D (Div. S) Division S Production: 1,500 subassemblies for external sale 200 subassemblies for Div. P 300 Widgets for external sale Subassemblies to outside get $60 Widgets get $25 Subassemblies get $20 (at TP of $220)

W. BentzA&MIS EFG Overview The key issue is to set a transfer price that takes advantage of excess capacity when it exists. The fact that one cannot earn the market price may be more of a temporary problem than a measure of one’s inefficiency. Generally $200 < price < $240, but this depends on opportunity costs.

W. BentzA&MIS EFG2 Anyone? Do you want another problem?

W. BentzA&MIS EFG2 Company Division S (Supplying) makes: Subassemblies Price$270 Variable cost 210 Contribution margin$ 60 (1) Widgets Price$150 Variable cost 125 Contribution margin$ 25 (4)

W. BentzA&MIS EFG2 Company Division P (Purchasing) makes: Product B Price$400 Variable cost* 160 Contribution margin$240 (2-$30) Gadgets Price$180 Variable cost 150 Contribution margin$ 30 (2)

W. BentzA&MIS EFG2 Company Case A: Maximum external sales: Division S - 1,500 subassemblies (capacity = 2,000 units) Division P Gadgets (capacity = 1,000 units)

W. BentzA&MIS EFG2 Company Division S [Capacity: 2,000 units] Division P [Capacity: 1,000 units] Product B Gadgets Widgets Subassemblies External Customers Subassemblies

W. BentzA&MIS EFG2 - Case A Division S Production Plan: 1,500 subassemblies for external sale 500 subassemblies for Div. P Division P Production Plan: 500 units of Product B 400 Gadgets 100 units of idle capacity

W. BentzA&MIS EFG2 - Case B Case B: Maximum external sales: Division S - 1,600 subassemblies widgets (capacity = 2,000 units) Division P Gadgets (capacity = 1,000 units)

W. BentzA&MIS EFG2 - Case B Division S Production Plan: 1,600 subassemblies for external sale 400 subassemblies to Div. P Division P Production Plan: 400 units of Product B 600 Gadgets

W. BentzA&MIS EFG2 - Case C Case C: Maximum sales: Division S - 1,500 subassemblies widgets - 1,000 subs to $240 (capacity = 2,000 units)

W. BentzA&MIS EFG2 - Case C (Div. S) Division S Production Plan: 1,500 subassemblies for external sale 500 subassemblies for Div. P 0 Widgets

W. BentzA&MIS EFG2 - Case D (Div. S) Case D: Maximum external sales: Division S - 1,500 subassemblies widgets - 1,000 subs to P for $220 (capacity = 2,000 units)

W. BentzA&MIS EFG2 Case D (Div. S) Division S Production: 1,500 subassemblies for external sale 200 subassemblies for Div. P 300 Widgets for external sale Subassemblies to outside get $60 Widgets get $25 Subassemblies get $20 (at TP of $220)

W. BentzA&MIS EFG2 Overview The key issue is to set a transfer price that takes advantage of excess capacity when it exists. The fact that one cannot earn the market price may be more of a temporary problem than a measure of one’s inefficiency. Generally $210 < price < $240, but this depends on opportunity costs.

W. BentzA&MIS Quiz Discussion?

W. BentzA&MIS Final Examination Discussion Content Preparation Presentation Grading

W. BentzA&MIS 52549