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

2. 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.)

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

4. 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.

5. 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.

6. 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

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

8. 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

9. 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

10. W. BentzA&MIS 52510 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.

11. W. BentzA&MIS 52511 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

12. W. BentzA&MIS 52512 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.

13. W. BentzA&MIS 52513 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.”

14. W. BentzA&MIS 52514 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.

15. W. BentzA&MIS 52515 Artic Delights TotalPer Unit Sales$17,500 $ 1.75 Variable cost 10,000 1.00 Contribution margin$ 7,500 $.75 Machine & rental cost 6,000.60 Income from operations$ 1,500 $.15

16. W. BentzA&MIS 52516 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.

17. W. BentzA&MIS 52517 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.

18. W. BentzA&MIS 52518 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.

19. W. BentzA&MIS 52519 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.

20. W. BentzA&MIS 52520 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.

21. W. BentzA&MIS 52521 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)

22. W. BentzA&MIS 52522 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)

23. W. BentzA&MIS 52523 EFG Company Case A: Maximum external sales: Division S - 1,600 subassemblies (capacity = 2,000 units) Division P - 500 Gadgets (capacity = 1,000 units)

24. W. BentzA&MIS 52524 EFG Company Division S [Capacity: 2,000 units] Division P [Capacity: 1,000 units] Product B Gadgets Widgets Subassemblies External Customers Subassemblies

25. W. BentzA&MIS 52525 EFG - Case A Sales constraints or projections: 600 Gadgets to outside customers 1,600 Subassemblies outside 200 Widgets to outside customers

26. W. BentzA&MIS 52526 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

27. W. BentzA&MIS 52527 EFG - Case B Case B: Maximum external sales: Division S - 1,600 subassemblies - 200 widgets (capacity = 2,000 units) Division P - 600 Gadgets (capacity = 1,000 units)

28. W. BentzA&MIS 52528 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

29. W. BentzA&MIS 52529 EFG - Case C Case C: Maximum external sales: Division S - 1,500 subassemblies - 200 widgets - 600 subs to P @ $240 (capacity = 2,000 units)

30. W. BentzA&MIS 52530 EFG - Case C (Div. S) Division S Production Plan: 1,500 subassemblies for external sale 500 subassemblies for Div. P 0 Widgets

31. W. BentzA&MIS 52531 EFG - Case D (Div. S) Case D: Maximum external sales: Division S - 1,500 subassemblies - 300 widgets - 600 subs to P for $220 (capacity = 2,000 units)

32. W. BentzA&MIS 52532 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)

33. W. BentzA&MIS 52533 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.

34. W. BentzA&MIS 52534 EFG2 Anyone? Do you want another problem?

35. W. BentzA&MIS 52535 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)

36. W. BentzA&MIS 52536 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)

37. W. BentzA&MIS 52537 EFG2 Company Case A: Maximum external sales: Division S - 1,500 subassemblies (capacity = 2,000 units) Division P - 400 Gadgets (capacity = 1,000 units)

38. W. BentzA&MIS 52538 EFG2 Company Division S [Capacity: 2,000 units] Division P [Capacity: 1,000 units] Product B Gadgets Widgets Subassemblies External Customers Subassemblies

39. W. BentzA&MIS 52539 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

40. W. BentzA&MIS 52540 EFG2 - Case B Case B: Maximum external sales: Division S - 1,600 subassemblies - 500 widgets (capacity = 2,000 units) Division P - 600 Gadgets (capacity = 1,000 units)

41. W. BentzA&MIS 52541 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

42. W. BentzA&MIS 52542 EFG2 - Case C Case C: Maximum sales: Division S - 1,500 subassemblies - 200 widgets - 1,000 subs to P @ $240 (capacity = 2,000 units)

43. W. BentzA&MIS 52543 EFG2 - Case C (Div. S) Division S Production Plan: 1,500 subassemblies for external sale 500 subassemblies for Div. P 0 Widgets

44. W. BentzA&MIS 52544 EFG2 - Case D (Div. S) Case D: Maximum external sales: Division S - 1,500 subassemblies - 300 widgets - 1,000 subs to P for $220 (capacity = 2,000 units)

45. W. BentzA&MIS 52545 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)

46. W. BentzA&MIS 52546 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.

47. W. BentzA&MIS 52547 Quiz Discussion?

48. W. BentzA&MIS 52548 Final Examination Discussion Content Preparation Presentation Grading

49. W. BentzA&MIS 52549