Cost Based Tp Mcs (1)

8/12/2019 Cost Based Tp Mcs (1)

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Describe salient features of cost based & market price based transfer

pricing methods.

Cost-based Transfer Prices:

The transfer price is based on the production cost of the upstream division. A cost-based transfer price requires that the following criteria be specified:

Actual cost or budgeted (standard) cost. Full cost or variable cost. The amount of markup, if any, to allow the upstream division to earn a

profit on the transferred product.

Cost-based transfer prices can also align managerial incentives with corporategoals, if various factors are properly considered, including the outside marketopportunities for both divisions, and possible capacity constraints of the upstreamdivision.

First consider the case in which the upstream division sells the intermediateproduct to external customers as well as to the downstream division. In thissituation, capacity constraints are crucial. If the upstream division has excesscapacity, a cost-based transfer price using the variable cost of production will alignincentives, because the upstream division is indifferent about the transfer, and the

downstream division will fully incorporate the companys incremental cost ofmaking the intermediate product in its production and marketing decisions.However, senior management might want to allow the upstream division to markup the transfer price a little above variable cost, to provide that division positiveincentives to engage in the transfer.

If the upstream division has a capacity constraint, transfers to the downstreamdivision displace external sales. In this case, in order to align incentives, theopportunity cost of these lost sales must be passed on to the downstream division,which is accomplished by setting the transfer price equal to the upstream divisions

external market sales price.

Next consider the case in which there is no external market for the upstreamdivision. If the upstream division is to be treated as a profit center, it must beallowed the opportunity to recover its full cost of production plus a reasonable

profit. If the downstream division is charged the full cost of production, incentivesare aligned because the downstream division will refuse the transfer under onlytwo circumstances:

- First, if the downstream division can source the intermediate product for alower cost elsewhere;


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- Second, if the downstream division cannot generate a reasonable profit onthe sale of the final product when it pays the upstream divisions full cost of

production for the intermediate product.

If the downstream division can source the intermediate product for a lower costelsewhere, to the extent the upstream divisions full cost of production reflects its

future long-run average cost, the company should consider eliminating theupstream division. If the downstream division cannot generate a reasonable profiton the sale of the final product when it pays the upstream divisions full cost of

production for the intermediate product, the optimal corporate decision might be toclose the upstream division and stop production and sale of the final product.However, if either the upstream division or the downstream division manufacturesand markets multiple products, the analysis becomes more complex. Also, if the

downstream division can source the intermediate product from an external supplierfor a price greater than the upstream divisions full cost, but less than full cost plus

a reasonable profit margin for the upstream division, suboptimal decisions couldresult.

Market-based Transfer Prices:

In the presence of competitive and stable external markets for the transferredproduct, many firms use the external market price as the transfer price.

Microeconomic theory shows that when divisional managers strive to maximizedivisional profits, a market-based transfer price aligns their incentives withowners incentives of maximizing overall corporate profits. The transfer will occurwhen it is in the best interests of shareholders, and the transfer will be refused by atleast one divisional manager when shareholders would prefer for the transfer not tooccur. The upstream division is generally indifferent between receiving the market

price from an external customer and receiving the same price from an internal

customer. Consequently, the determining factor is whether the downstreamdivision is willing to pay the market price. If the downstream division is willing todo so, the implication is that the downstream division can generate incremental

profits for the company by purchasing the product from the upstream division andeither reselling it or using the product in its own production process. On the otherhand, if the downstream division is unwilling to pay the market price, theimplication is that corporate profits are maximized when the upstream divisionsells the product on the external market, even if this leaves the downstreamdivision idle. Sometimes, there are cost savings on internal transfers compared

with external sales. These savings might arise, for example, because the upstreamdivision can avoid a customer credit check and collection efforts, and the


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downstream division might avoid inspection procedures in the receivingdepartment. Market-based transfer pricing continues to align managerial incentiveswith corporate goals, even in the presence of these cost savings, if appropriateadjustments are made to the transfer price (i.e., the market-based transfer price

should be reduced by these cost savings).

However, many intermediate products do not have readily-available market prices.Examples are shown in the table above: a pharmaceutical company with a drugunder patent protection (an effective monopoly); and an appliance company thatmakes component parts in the Parts Division and transfers those parts to itsassembly divisions. Obviously, if there is no market price, a market-based transfer

price cannot be used.

A disadvantage of a market-based transfer price is that the prices for somecommodities can fluctuate widely and quickly. Companies sometimes attempt to

protect divisional managers from these large unpredictable price changes.

Explain the problem faced in pricing corporate services staff to biz. Unit-

assume profit centers decentralization?

Services are intangible in nature. This characteristic of services makes it difficultfor pricing. Charging business units for services furnished by corporate staff units

becomes challenging work due to intangibility of services. While pricing corporateservices, we exclude the cost of central service staff units over which businessunits have no control (e.g., central accounting, public relations, andadministration). If these costs are charged at all, they are allocated, and theallocations do not include a profit component. The allocations are not transfer

prices.

We need to consider two types of transfers:

For central services that the receiving unit must accept but can at leastpartially control the amount used. For central services that the business unit can decide whether or not to use.

Business units may be required to use company staffs for services such asinformation technology and research and development. In these situations, the

business unit manager cannot control the efficiency with which these activities areperformed but can control the amount of the service received. There are threeschools of thought about such services. One school holds that a business unitshould pay the standard variable cost of the discretionary services. If it pays less


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than this, it will be motivated to use more of the service than is economicallyjustified. On the other hand, if business unit managers are required to pay morethan the variable cost,they might not elect to use certain services that seniormanagement believes worthwhile from the company's viewpoint. This possibility

is most likely when senior management introduces a new service, such as a newproject analysis program. The low price is analogous to the introductory price thatcompanies sometimes use for new products.A second school of thought advocatesa price equal to the standard variable cost plus a fair share of the standard fixedcosts-that is, the full cost. Proponents argue that if the business units do not believethe services are worth at least this amount, something is wrong with either thequality or the efficiency of the service unit. Full cost represents the company's longrun costs, and this is the amount that should be paid.

A third school advocates a price that is equivalent to the market price, or to

standard full cost plus a profit margin. The market price would be used if available(e.g., costs charged by a computer service bureau); if not, the price would be fullcost plus a return on investment. The rationale for this position is that the capitalemployed by service units should earn a return just as the capital employed bymanufacturing units does. Also, the business units would incur the investment ifthey provided their own service.

Optional Use of Services

In some cases, management may decide that business units can choose whether touse central service units. Business units may procure the service from outside,develop their own capability, or choose not to use the service at all. This type ofarrangement is most often found for such activities as information technology,internal consulting groups, and maintenance work. These service centers areindependent; they must stand on their own feet. If the internal services are notcompetitive with outside providers, the scope of their activity will be contracted ortheir services may be outsourced completely .For example, Commodore BusinessMachines outsourced one of its central service activities-customer service-toFederal Express. James Reeder, Commodore's vice president of customersatisfaction, said," At that time we didn't have the greatest reputation for customer

service and satisfaction. But this was FedEx's specialty, handling more than300,000 calls for service each day. Commodore arranged for FedEx to handle theentire telephone customer service operation from FedEx's hub in Memphis. Afterlosing $29 million online the previous year, Borders Group turned to rivalAmazon.com to manage its online sales. Borders get to maintain an Internet saleschannel and gains the operational effectiveness provided by Amazon.com while

being able to focus on the growth of its bricks and mortar business. In thissituation, business unit managers control both the amount and the efficiency of thecentral services. Under these conditions, these central groups are profit centers.Their transfer prices should be based on the same considerations as those

governing other transfer prices.


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Cost Based Tp Mcs (1)