W. BentzEMBA 8021 Agenda Today Review some chapter 12 ideas Outline transfer pricing issues Go over EVA case Outsource, Inc.

W. BentzEMBA 8022 Profit Centers Responsibility elements –Sales prices –Sales volumes –Sales mix –Promotional activities –Other terms of sale

W. BentzEMBA 8023 Profit Centers (Cont.) Direct cost elements –Production activity costs –Order-getting costs –Order-filling costs –Marketing expenses –Support activity costs –Costs associated with other terms of sale

W. BentzEMBA 8024 Profit Centers (Cont.) Other possible responsibility elements –Receivables –Inventories –Plant & equipment Examples?

W. BentzEMBA 8025 Investment Centers Profit centers with additional responsibility elements –Investment in current operating assets –Investment in plant & equipment

W. BentzEMBA 8026 Investment Centers Challenges –Allocation of common assets Cash Receivables Warehouse space Transportation resources –Valuation of investment Inflation and currency effects

W. BentzEMBA 8027 Invest.Centers (Cont.) Examples –Lazarus store in City Center Mall –Marysville Honda plant –EDS processing centers

W. BentzEMBA 8028 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. BentzEMBA 8029 Divisions Divisions vary greatly in size Financial controls dominate since the decision-making is decentralized

W. BentzEMBA 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. BentzEMBA Transfer Pricing In a standard cost system, when products are transferred out of a cost center, they are transferred at their standard cost. The difference between the standard cost credited (received) for the product transferred, and the cost of the resources that are allowed by the standards for the production achieved, are the cost variances.

W. BentzEMBA Manufacturing Process 1 Support Manufacturing Process 1 Inputs Outputs at Standard Cost Materials Labor Support Manufacturing Process 2 Difference between cost of inputs and standard cost of outputs = variances

W. BentzEMBA Support Service When a support service is charged to other entities at a predetermined price, that amounts to a transfer price. If the transfer price is a budgeted cost, as in the previous slides, the difference between the budgeted prices of the services provided to others, and the cost of resources used by the entity, are cost variances.

W. BentzEMBA Services in General When a service is provided to other entities in the same firm at a predetermined price, that amounts to a transfer price. If the transfer price were a budgeted cost, then like the previous slides, the difference between the budgeted cost of the services provided and the cost of resources actually used to provide those services would be cost variances.

W. BentzEMBA Therefore, we have dealt with transfer prices in the context of cost centers. The transfers between cost centers can be made at budgeted, standard, or actual cost. The objective of a cost center is to create a positive difference between the actual costs incurred and the budgeted cost allowance for the output levels achieved.

W. BentzEMBA Revenue Centers In the case of revenue centers, we are tracking revenues by responsibility center, where the emphasis in on generating revenues. Normally, there are no transfers involved with revenue centers.

W. BentzEMBA Profit & Investment Centers Profit centers and investment centers have profit responsibility--usually in the form of the control of both revenues and costs. Therefore, transferring goods and services out of a profit center at cost is inconsistent with the idea of having profit responsibility. Normally, for true profit centers, there should be a meaningful “profit” component.

W. BentzEMBA Pricing Goods and Services In a market economy, prices determine economic activity. Prices determine what resources are offered, and how they are used to produce which products and services. Activities cease when they are no longer “economic”; but persist when they are “economic.” Economic activity is the result of independent decisions made based on available prices.

W. BentzEMBA 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. BentzEMBA Decentralization Purposes Decentralize managerial responsibilities to local managers. Provide managerial incentives to operating executives Isolate economic efficiency by responsible entity

W. BentzEMBA Decentralization Purposes Distribute overall profitability among contributing entities Distribute overall profitability among taxing entities

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

W. BentzEMBA Note!! The selling division’s “price” is the buying division’s cost for divisional performance measurement purposes. Production mix and volume decisions are incremental analysis-type decisions in a multi- entity context.

W. BentzEMBA Three Perspectives The total firm Selling division Purchasing division

W. BentzEMBA 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. BentzEMBA 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. BentzEMBA Artic Delights 2.Artic delights should produce so long as the purchase price is above variable cost of $1 per gallon. Do companies ever produce for less than variable cost? How would one analyze a situation like that? 3.If stands can but ice cream for $1.50, Artic Delights will have to drop its price.

W. BentzEMBA Artic Delights 4.How does the transfer price affect the profitability of (a) Artic Delights excluding the stands, (b) each Sandwich stands, and (c) Artic Delights and its stands. (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. BentzEMBA 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. BentzEMBA 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. BentzEMBA EFG Company Division S (Supplying) Subassemblies: Price$260 Variable cost 200 Contribution margin$ 60 Widgets: Price$150 Variable cost 125 Contribution margin$ 25

W. BentzEMBA EFG Company Division P (Purchasing) Product B: Price$400 Variable cost* 160 Contribution margin$240 Gadget: Price$180 Variable cost 150 Contribution margin$ 30

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

W. BentzEMBA EFG - Case A Division S Production: 1,600 subassemblies for external sale 400 subassemblies for Div. P Division P Production: 400 units of Product B 500 Gadgets

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

W. BentzEMBA EFG - Case C Case C: Maximum external sales: Division S - 1,500 subassemblies widgets subs to P (capacity = 2,000 units)

W. BentzEMBA EFG Case C (Div. S) Division S Production: 1,500 subassemblies for external sale 500 subassemblies for Div. P 0 Widgets

W. BentzEMBA 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. BentzEMBA 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. BentzEMBA 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 the other markets.

W. BentzEMBA Evaluation Questions Were any of the “calculators” like the ones for learning curves and the internal rate of return of any benefit? Would calculators be useful for such topics as standard cost systems, etc. Looking back, were the graded problems/cases useful in terms of getting together to work on homework? Would you recommend quizzes again?

W. BentzEMBA Evaluation Questions Was having some MC questions available to study useful? Was the web page helpful? If yes, what would make it more helpful?

W. BentzEMBA Final Examination Discussion Content Preparation Presentation Grading

W. BentzEMBA Quiz Discussion?

W. BentzEMBA 80247