Profit Centers and Transfer Pricing

1
Profit Centers and Transfer Pricing

• Why use transfer prices? To solve agency
  problems induced by performance measurement
  without greatly reducing the controllability of
  the measure.

2
Review and Linkage

• The cost allocation in John Daly essentially
  partitioned the additional contribution from New
  between the two managers.
• Transfer prices perform a similar function. They
  partition the profit from an outside transaction
  between the buying and selling divisions.
• Fairness
• Motivation
• Controllability

3
The situation

• Interdependent divisions a manufacturing
  division and a marketing division, both treated
  as profit centers.
• If each manager is measured on his or her own
  performance, they will have no incentive to work
  together the performance measure will distort
  their incentive to cooperate.

4
Whats the big deal?

• Why not just use overall firm profit? This is
  another way of saying . . .
• Transfer pricing can partially solve this problem
  by giving the manufacturing manager the incentive
  to worry about how his actions affect the
  marketing division without evaluating him on the
  total performance of marketing.

5
What does a transfer price do?

• It allocates a chunk of profit between the two
  interdependent divisions.

6
Example John Daly revisited

• Dept. 1 spends 100,000 making Nifty, which it
  then sells for 300,000. Some of Dept. 1s
  product goes to Dept. 2?
• Dept 2 spends 100,000 converting Nifty to New,
  which it then sells for 425,000.
• What is each departments contribution to Johns
  profit? What is Johns contribution? Profit?
• If John wants to share his profit with his
  division managers, say 50/50, how should he
  allocate profit across the two divisions?

7
Transfer prices decentralize the monitoring
function to users of the product(s) and /or
service(s), but . . .
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they also create problems.

• Sometimes the selling division has monopoly power
  it can exploit to the detriment of both the
  buying division and the firm.
• They never completely solve the performance
  evaluation problems. If they could, there would
  be no reason for the two divisions to be in the
  same firm.

9
Profit centers and transfer pricing
TRANSFER PRICE
A PRICE CHARGED BY ONE SEGMENT OF ANORGANIZATION
FOR A PRODUCT OR SERVICETHAT IT SUPPLIES TO
ANOTHER SEGMENT OFTHE ORGANIZATION.
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Objectives of transfer pricing schemes

• Encourage managers to make decisions that are in
  the organizations best interest.
• Provide information for evaluation of business
  units and managers.
• Minimize tax obligations (we will ignore)
• Constraint The scheme chosen should require
  little intervention by top management.

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How are transfer prices set?

• Does a correct transfer price exist?
• A well-developed, competitive outside market for
  the intermediate good or service . . .
• No outside market for the transferred good or
  service.
• Otherwise
• Choose a policy
• Negotiate

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Domestic Transfer Pricing Method Survey

• Market based 26
• Cost based
• Variable costs 3
• Absorption or full costs 49
• Other 1
• Negotiated 17
• Other 4
• 100

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TP options . . .

• Variable
• Selling division performance evaluation
• Lump sum transfer payment
• Full costs
• Inefficiencies
• Performance evaluation (allocations)
• Multiple divisions (profit on profit)
• Profit Pro-ration
• Dual pricing
• Market prices (discipline, efficiency)
• Negotiation

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Comparison
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A Bit of Guiding Theory

• The monopoly problem
• Cause The buying division cannot or may not buy
  outside.
• Effect Restricted output and higher prices
• Example The legal department of a firm
• What is the optimal level of legal service?
• What quantity of legal services will be provided?

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Legal services monopolywhat should be provided?
DollarPrice
Average variable cost of providing legal services
100/hr.
Optimal quantity of legal services
Quantity of Legal Services
17
Legal services monopoly what quantity will be
provided?
Dollars
Demand curve for legal services
Valuable projects foregone
Profit Maximizing Price
Profit
100/hr
Average variable cost of providing legal services
Quantity of legal services provided by monopolist
legal department
Optimal quantity of legal services
Quantity of Legal Services
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What if there is a market price?
Demand curve for legal services
Dollars
Profit Maximizing Price
Valuable projects foregone
Market Price
Profit
100/hr
Average variable cost of providing legal services
Bargaining range
Optimal quantity of legal services
Quantity of Legal Services
Quantity of legal services provided by monopolist
legal department
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Bargaining
Marginal Cost Curve (Supply Curve) facing Buying
Division
Prices
XPm
Bargaining Range for Transfer Prices
XP
Marginal Benefit Curve (Demand Curve) facing the
Selling Division
XPd
Quantity
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Finding a reasonable transfer price

• If there is a ready market, use the price/s from
  the market.
• Discipline
• Efficiency
• No market prices or excess/idle capacity?
• Start with marginal cost (average variable cost)
• If it makes sense, go higher, but expect the
  usual problems

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The unifying principle is opportunity cost
The general transfer pricing rule
T VC OC
VC OUTLAY COSTS INCURRED TO THE POINT
OF TRANSFER USUALLY APPROXIMATED BY
STANDARD VARIABLE COST
OC OPPORTUNITY COST TO THE FIRM
(I.E., CONTRIBUTION FOREGONE CM)
Note that CM SP - VC, so VC OC SP - the
market pricewhen OC gt 0, less adjustments.
22
Transfer pricing Crossville Company
At practical capacity, the Fabricating Division
of Crossville Company has facilities to produce
8,000 units per month. Each unit requires five
direct labor hours. The Assembly Division has
forwarded a requisition for 8,000 units to the
Fabricating Division. Since Crossville uses a
market-based transfer pricing system,
contribution margin using a 50 market price
would be 168,000. Georges, Inc., a competitor,
also sells the units for 50. The receipt of this
requisition from Assembly upset the Fabricating
manager as he had just been approached by an
outside buyer with a rush order for 5,000 units
at a 56 unit selling price. Top managements
initial reaction is to reject the offer.
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Crossville Company
A. Does top management have a transfer pricing
policy?
B. What is the minimum transfer price required
by the selling division, Fabricating?
C. What is the maximum transfer price required
by the buying division?
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Crossville Company
D. Will the two division managers agree to the
transfer?
25
Crossvillle Company
Which of the following circumstances will lead to
goal congruence between the managers and the
overall firm? Why?
1. The policy enforced is market price transfers.
Will the managers agree to transfer?
Is the transfer in the best interest of the
company?
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Crossville Company
Is the transfer in the best interest of the
company?
Minimize costs
Internal transfer
27
Crossville Company
2. Fabricating has adequate idle capacity.
What price will the Fabrication manager ask?
What price will the Assembly manager be willing
to pay?
28
Crossville Company
3. Fabricating is forced to transfer product in
lieu of selling 5,000 units outside.
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Handout problems

• Adler IndustriesPress Company

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Negotiated market-based prices

• Some form of outside market for the intermediate
  product.
• Sharing of all market information among the
  negotiators.
• Freedom to buy or sell outside. This provides
  the necessary discipline to the bargaining
  process.
• Support and occasional involvement of top
  management.

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Its limitations

• Time consuming
• Leads to conflict within firms
• It makes the measurement of divisional
  profitability sensitive to the negotiating skills
  of managers.
• It requires the time of top management to oversee
  and mediate.
• It may lead to a suboptimal level of output.

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The end!