Transfer Pricing/Strategy

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Transfer Pricing/Strategy

• Case 18-2
• Presented by Group 3
• Nidhi Jain, Ajay Aggarwal,
• Thomas Giap, Qingwei Meng

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Transfer Pricing

• Definition
• Determination of exchange price when different
  business units within a firm exchange the
  products and services
• When it is important
• Firm with vertical integration, having different
  value-creating activities in the value chain
• Objective
• To motivate managers
• To provide appropriate incentive for managers
• To provide basis for fairly rewarding managers
• Minimize taxes locally as well as internationally
• To develop strategic partnership

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Transfer Pricing Methods

• Variable Cost Method
• Transfer price variable cost of selling unit
  markup
• Full cost Method
• Transfer price Variable Cost allocated fixed
  cost
• Market Price Method
• Transfer price current price for the selling
  units in the market
• Negotiated price method

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Choosing the Right Transfer Price

• Is there an outside supplier?
• Is the sellers variable cost less than the
  market price?
• Is the selling unit operating at full capacity?

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Cole Division Assumptions

• Cole Division will buy components only from
  Bayside division I.e. there is no outside
  supplier
• Cole can sell inside or outside the firm
• Cole division is at full capacity

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Robert Products Inc.
INTERNAL TO THE FIRM
EXTERNAL FOREIGN
Bayside
Price 400
Wales Company
Price 600
Cole
Price 1,250
Variable Cost 600500 1,100
London Company
Diamond
Price 1,500
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Cole Division
Internal to the firm
External to the firm
Bayside division
3,500 Units, var cost 250 per unit
3,000 Units, var cost 300 per unit
Price 600
Price 500
Cole Division
Further processing variable cost- 400
Further processing variable cost- 500
price 1,100 or 1,500
price 1,250
?
Diamond division
Wales company
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Diamond Division
Cole Division
London Company
Bayside division
Variable cost-200
Variable cost - 300
Price 400
Price 600
London company
Diamond division
Further processing variable cost- 500
3,000 Units, price- 1,500
3,000 Units
Diamond Division
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Cole Division

• If there is an outside supply ----Yes.
• Is the sellers variable costs lt outside price?
  Yes.
• Does seller have excess capacity? No.
• If contribution from outside purchase gt
  contribution from inside purchase . . .
• ? Decision to Transfer Sell outside.

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Transfer Pricing
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Transfer Pricing
The firm benefits more from Option 2.
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Strategic Factors

• International Transfer Pricing Consideration
• Tax Rate- minimize taxes locally as well
  internationally
• Exchange Rate
• Custom Charges
• Risk of expropriation
• Currency Restriction
• Strategic relationship
• Assist bayside division to grow
• Gain entrance in the new country
• Suppliers quality or name

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Transfer Pricing with ABC
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Q1. Why did Teva introduce transfer pricing

• Teva, a multinational pharmaceutical company,
  solved its transfer pricing problems by using
  activity-based costing
• Teva reorganized its pharmaceutical operations
  into 1 operation division (with 4 manufacturing
  plants) and 3 marketing divisions
• Marketing divisions are organized into the US
  marketing and the local market, and the rest of
  the world
• Responsible for decisions about sales, product
  mix, pricing and customer relationships
• Marketing were evaluated on sales, not profit
• Manufacturing plants were measured how meeting
  expense budgets and delivered the right orders on
  time
• Cost system emphasized variable costs materials
  expenses and direct labor. All other costs were
  considered fixed
• Decided to introduce transfer pricing system that
  would enhance profit consciousness and improve
  coordination between operations and marketing

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Q2. What Everyone Wanted

• Senior Management
• System that encourages decisions consistent with
  long-run profitability
• Encourage actions that benefits the overall
  companys profitability
• Allows managers to distinguish costs relevant for
  short-run decisions
• Transfer prices could be used to support
  decisions in both marketing and operating
  divisions, including

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Q2. What Everyone Wanted

• Division Managers
• Transfer prices would report the financial
  performance of their divisions fairly
• Managers could influence the reported performance
  of their divisions by making business decisions
  within their scope of authority
• Performance should reflect changes in product
  mix, improved efficiency, investment in new
  equipment, and organizational changes
• Decisions made by managers of marketing divisions
  would reflect both sales revenue and associated
  expenses incurred in the operations division
• The system must anticipate that division managers
  would examine the method and take actions that
  maximized the reported performance of their
  divisions

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Q2. What Everyone Wanted

• Financial Staff
• Credible and reliable information for decision
  making at all levels of the organization without
  excessive arguments and controversy
• System that is clear, easy to explain, and easy
  to use
• Updates should be easy
• Components of the transfer price calculation
  should promote good understanding of the
  underlying factors driving costs
• System would be used for internal charging of
  costs from the operations division to the
  marketing divisions

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Q3. Why Traditional Transfer Pricing Method not
work

• Variable Cost Method
• Covering only ingredients and packaging materials
  which was inadequate for their purposes
• Marketing divisions would report extremely high
  profits because they were being charged for
  materials only
• Operations divisions would get credit only for
  expenses of purchased materials
• No motivation to control labor or other fixed
  expenses
• Marginal cost transfer price would give the
  marketing divisions no incentive to shift their
  source of supply
• Measuring profits as price less materials cost
  would continue to allow marketing and sales
  decisions to be make without regard to their
  implications for production capacity and long-run
  costs and overall company profitability
• Full cost Method
• Overhead did not capture the actual cost
  structure in Tevas plant
• Market Price Method
• No market existed for manufactured and packaged
  products that had not been distributed or
  marketed to customers
• Negotiated price method
• Would lead to endless arguments

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Q3. Why did ABC work?

• First decided to implement ABC in its largest
  production plant
• A multidisciplinary project team develop an
  activity dictionary, drive factory costs to
  activities, identify cost drivers for each
  activity, collect data, and calculate ABC based
  product costs
• Originally the ABC models were retrospective
• Calculating the activities costs, activity cost
  driver rates, and product costs for the prior
  year
• End of 1993, senior management wanted to use ABC
  to calculate transfer prices for the coming year
• Teva built its ABC production cost model for 1994
  using data from the first three quarters 1993
• Group decided to use the forecasted costs based
  on budgeted expense data, forecasted volumes and
  mix of sales, projected process utilization and
  efficiencies to calculate the transfer price

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Q4. Using ABC costs for Transfer Pricing
Manufacturing Plants
Cost Pools
Unit Costs
Batch Costs
Product Specific
Plant Level

• Charges based on actual quantities of each
  individual products acquire
• Materials and labor

• Charged for actual number of production and
  packaging batches of each product order

• Charges based on budgeted numbers
• No individual product is sold to more than one
  marketing division

• Based on the budgeted use of the capacity of the
  4 manufacturing facilities

Marketing Division
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Q4. The ABC Transfer Price Model Structure

• ABC hierarchical structure of unit, batch,
  product sustaining and plant-level costs
• Unit Level Costs direct expenses associated
  with producing individual product units such as
  tablets, capsules, and ampoules
• Includes cost of raw materials, packaging
  materials, and direct wages paid to production
  workers
• Batch-level costs expenses of resources used
  for each production or packaging batch.
• Costs of preparation, setup, cleaning, quality
  control, lab testing, and computer, packaging and
  production management
• Lot sizes for production are predetermined based
  on the capacity of the containers in the
  production line
• Product sustaining costs expenses incurred in
  registering the products, making changes to a
  products production processes, and designing the
  package
• Plant-level costs cost of maintaining the
  capacity of production lines including
  depreciation, cost of safety inspections,
  insurance, and general expenses

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Q4. Using ABC costs for Transfer Pricing

• Prices are set for the coming year based on
  budgeted data
• Calculates standard activity cost driver rates
  for each activity
• Enables product costs to be calculated in a
  predictable manner throughout the year
• Eliminates fluctuations in product costs caused
  by variations in actual spending, resource usage,
  and activity levels
• Activity cost driver rates are based on the
  practical capacity of each of the four plants
• Rates reflect the underlying efficiency and
  productivity of the plants without being
  influenced by fluctuations in forecasted or
  actual usage
• Transfer prices are calculated in two different
  procedures
• Assigns unit and batch-level costs
• Product-specific and plant-level costs

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Q5. Ongoing benefits from ABC Transfer Pricing
System

• Highlighted unused capacity shows where
  production can be expanded without spending
  additional money
• Capacity released by ceasing production of
  unprofitable products
• Investment decision for a new production line
  incorporates the cost and assignment of
  responsibility for the unused capacity in the
  early periods provides valuable realism to the
  demand forecasts provided by the marketing
  division
• Motivates cost reduction and production
  efficiencies in the manufacturing plant
• Identify ways to reduce unit and batch-level
  expenses
• Conduct common searches for lower-cost, more
  reliable, higher-quality suppliers to reduce
  variable materials costs
• Helps to determine which manufacturing facility
  is appropriate for different types of products

• Plant A has a relatively inflexible (high
  capital intensive) cost structure with high
  percentage of plant-level costs and low
  percentage of unit cost plant most appropriate
  for high-volume production
• Plant B is much more flexible and is appropriate
  for small batch sizes and test runs of newly
  introduced products

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Q5. Benefits of ABC - Unused Capacity

• Unused capacity occurs in two ways
• Declines in demand for products manufactured on
  an existing line
• Partial usage when a new production line is added
  because existing production lines cannot produce
  the additional quantities requested by one of the
  marketing divisions
• Marketing divisions are charged a lump-sum for
  the cost of maintaining the unused production
  capacity in an existing line
• Fosters a send of responsibility among marketing
  managers
• Increments in production capacity or
  manufacturing technology are paid for by the
  initiating marketing division
• Bears the costs of all additional resources
  supplied
• If the increment begins to be used by another
  marketing division then each marketing division
  would be charged based on its percentage of
  capacity used.

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Q5. Benefits to the Marketing Division

• Integrated budget process lets marketing managers
  plan their product mix with knowledge of the cost
  impact of their decisions
• Proposed increases in variety and complexity will
  be charged accordingly based on the increased
  demands on manufacturing facilities
• Marketing managers are given the flexible to
  decide when to accept small order from a customer
  or how much of a discount to grant for large
  orders based on cost details
• Marketing mangers can monitor closely the costs
  incurred in the manufacturing plants (fixed
  costs) because of separating out the unit and
  batch-level costs
• Responsibility for the fixed costs increment is
  clearly assignable to the requesting division
• Marketing managers can distinguish between
  products that cover all manufacturing costs
  versus those that cover only the unit and
  batch-level expenses
• Able to incorporate information about available
  capacity when they make decisions about pricing,
  product mix, and product introduction
• Led to decisions to sell 30 low-volume products
  to another company so Teva was able to freed-up
  capacity to handled production of new products or
  existing profitable products

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Q5. The Best News Harmony is Growing

• Unexpected benefit of activity-based transfer
  price system is the ability to measure profit
  performance under changing organizational
  structures
• Forecast potential impact of newly created profit
  centers by understanding cost behaviors at the
  activity and product level
• Enables executives to measure profit performance
  across organizational cost and profit centers
  boundaries
• ABC are not the primary information used for
  short-term operational decision making
• Current bottlenecks and lead-time considerations
  are the focus
• ABC provides guidance and insights about where to
  look
• ABC-based transfer prices has lead to a dramatic
  reduction in conflicts among marketing and
  manufacturing managers
• Managers have confidence in the production cost
  economics reported by the transfer price system

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Table 1.
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Table 2 Batch Level Transfer Price

• Cost of production for a packaging batch can
  vary among different products and among different
  plants
• Batch costs assigned to a particular order
  include two components
• A pro-rata share of the batch cost of production
  setup
• The full batch cost of the packaging setup

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Table 3. Monthly Debit May 1995
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Table 4. Annual Debit - 1995
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Table 5. 10 Leading Products

• Shows the profitability of a significant product
  family whose individual products are manufactured
  in different plants and are sold by more than one
  marketing division