Description
The documentation describes the transfer pricing policies of Albert's which is a large manufacturing company.
1. Background of the case
This case explains Albert Company’s (A large manufacturing company) transfer pricing policies. The company is organized into number of divisions. Each individual division is responsible for earning a satisfactory return. That is they are either considered as profit centers or investment centers and not as cost centers. The company is a highly vertically integrated company, where all the parts required for assembling the final parts are fabricated within the company Some divisions of the company fabricate parts, which are used for assembling by other divisions. The divisions which produce finished goods for the market are called “End-item Divisions”. As each division is considered as profit/investment center, they transfer the goods to other divisions within the company for a certain price called “Transfer Price”. The case questions the transfer pricing practices of the company and also the classification of divisions as either “Profit/Investment or Cost Center”
Some facts on the case:
1) The company has been following a Market Price based transfer price for products which are available in the market. In a case, where identical products are not available, the company decides the transfer price based on similar products available outside, even though it is less than ideal.
2) There are certain parts manufactured by certain divisions, which are not similar to those manufactured by outside companies. These items are called “Type K” items. 3) Type K items contribute 5 to 10% of the total volume of fabricating divisions. 4) Division F fabricates 10 “Type K” items, which is 75% of its total volume. 5) “Type K” item generally constitute around 5% of the total cost of end item divisions. 6) For “Type K” items, the company follows “Cost-based transfer pricing”, where the transfer prices are arrived on the basis of cost plus a profit.
Q1) the right transfer pricing model
According to the group, the current transfer pricing model followed by Albert Company is the best transfer price practice. (i.e.) Market price based transfer pricing for “General” items and Cost-based transfer pricing for “Type K” items. Transfer price is defined as the sum of out of pocket expenses and the opportunity cost. Transfer price = out of pocket expenses + opportunity cost “Type K” Items: In case of “Type K” items, the opportunity cost is calculated on the basis of “profit margin” and Out of Pocket Expenses is the estimated cost of an efficient producer. Transfer Price = Estimated cost of an efficient producer + Profit Margin The profit margin is calculated based on the return on assets / investments. Pros of using Cost-based Transfer Pricing: 1) Can be used, even when there is no comparable market prices
Cons of using Cost-based Transfer Pricing: 1) The simplest and most widely used base in deciding the profit margin is by taking percentage of costs as the base. But if this is done, there will be no account on the capital required / investment made. This is countered by taking the base as “Assets employed”. 2) When taking base as “Assets employed”, if historical costs of assets are used, then it will again affect the metric, as old assets are generally undervalued. This is countered by the company policy, stating that the depreciated book value cannot be less than one-half of the original cost. 3) It is difficult to arrive at the optimal profit objective, as it will be very subjective. This can be countered by keeping the division profit objective as the “Average division profit objective”. General Items: In case of general items which are available in the outside market, Transfer price = out of pocket expenses + opportunity cost Where the opportunity cost is the profit which the division will lose for not selling in the outside market. Opportunity cost (General Item) = Outside Selling Price (Minimum) – Out of pocket expenses The price considered is the lowest price available in the market, with the acceptable quality. This model is called the “market price based transfer price”, as the transfer price is decided by the market forces.
Pros of using “Market price based transfer pricing” method: 1) It is the most simplest and ideal method for transfer pricing 2) It induces Goal Congruence Cons of using “Market price based transfer pricing” method: 1) Sometimes may be difficult to get market prices, if the vendor knows that the intention is not to buy, but just to account for internal transfer. 2) If a company has invested significantly in facilities, it is unlikely to use outside services, unless the outside selling price is less than the company’s variable cost.
Division F:
Division F should be treated as “Cost Center” (Justification is in next section) This division produces about 75% of “Type K” Items: In case of “Cost Center” the division will not include “Profit margin” in its calculation for transfer pricing. Hence transfer pricing for division F shall be Transfer Pricing = Out of pocket expenses (The pros & cons of the decision are explained in the next section)
Other Divisions:
Other divisions which either fabricate less amount of “Type K” items and divisions which assemble intermediate or end items can be continued to be treated as “Profit Centers” and hence Market based transfer pricing for “General Items” and Cost based transfer pricing for “Type K” items can be used.
Q2) Division F: Profit/Investment Center or Cost Center
Arguments for Division F in favour of “Profit/Investment center” 1) 25% of Division F’s produce is available in the market and hence can be sold or bought in the market directly. 2) There will be no inefficiency creeping into the processes, as the division will keep on focusing on profits, either by reduction in costs or by improved selling price. In other words, they will be under constant pressure to improve their competitive performance. 3) The quality & speed of operating decisions may improve because they are being made by managers closest to the point of decision. Arguments against “Profit/Investment Center” 1) There might be an increase in frictions between divisions on argument over “Transfer Price”. An increase in profit for one manager, may mean a decrease in profit for another. Arguments for Division F in favour of “Cost Center” 1) 75% of the produce of the division is of “Type K” item, which doesn’t have a market outside and has to be transferred to internal divisions only. 2) The division’s main objective doesn’t seem to be profit, but to enable the functioning of other divisions. 3) Less than 5% contribution of “Type K” item from Division F in the end items.
4) Centralized divisions will reduce costs on additional management, staff personnel and record keeping. Arguments against Division F as a “Cost Center” 1) There could be lot of inefficiencies creeping into the system, as the division is no more pressurized to make profits. This will result in higher costs. 2) Quality of the output may also take a hit. 3) Decision makings may take a longer time, as every time, head office might have to involve.
Some of the above arguments can be countered by measuring appropriate metrics. The following metrics such as 1) 2) 3) 4) 5) 6) DPMO (defects per million opportunities) Efficiency & Effectiveness No of other division complaints Employee turnover % of wastage in raw materials Change in cost/unit (Month on Month basis) etc
Will keep a control on the in-efficiencies creeping into the system and also will keep a check on the quality.
From the above arguments, it can be inferred that “Division F” should be treated as a “Cost Center” rather than a “Profit/Investment” center.
doc_110757786.docx
The documentation describes the transfer pricing policies of Albert's which is a large manufacturing company.
1. Background of the case
This case explains Albert Company’s (A large manufacturing company) transfer pricing policies. The company is organized into number of divisions. Each individual division is responsible for earning a satisfactory return. That is they are either considered as profit centers or investment centers and not as cost centers. The company is a highly vertically integrated company, where all the parts required for assembling the final parts are fabricated within the company Some divisions of the company fabricate parts, which are used for assembling by other divisions. The divisions which produce finished goods for the market are called “End-item Divisions”. As each division is considered as profit/investment center, they transfer the goods to other divisions within the company for a certain price called “Transfer Price”. The case questions the transfer pricing practices of the company and also the classification of divisions as either “Profit/Investment or Cost Center”
Some facts on the case:
1) The company has been following a Market Price based transfer price for products which are available in the market. In a case, where identical products are not available, the company decides the transfer price based on similar products available outside, even though it is less than ideal.
2) There are certain parts manufactured by certain divisions, which are not similar to those manufactured by outside companies. These items are called “Type K” items. 3) Type K items contribute 5 to 10% of the total volume of fabricating divisions. 4) Division F fabricates 10 “Type K” items, which is 75% of its total volume. 5) “Type K” item generally constitute around 5% of the total cost of end item divisions. 6) For “Type K” items, the company follows “Cost-based transfer pricing”, where the transfer prices are arrived on the basis of cost plus a profit.
Q1) the right transfer pricing model
According to the group, the current transfer pricing model followed by Albert Company is the best transfer price practice. (i.e.) Market price based transfer pricing for “General” items and Cost-based transfer pricing for “Type K” items. Transfer price is defined as the sum of out of pocket expenses and the opportunity cost. Transfer price = out of pocket expenses + opportunity cost “Type K” Items: In case of “Type K” items, the opportunity cost is calculated on the basis of “profit margin” and Out of Pocket Expenses is the estimated cost of an efficient producer. Transfer Price = Estimated cost of an efficient producer + Profit Margin The profit margin is calculated based on the return on assets / investments. Pros of using Cost-based Transfer Pricing: 1) Can be used, even when there is no comparable market prices
Cons of using Cost-based Transfer Pricing: 1) The simplest and most widely used base in deciding the profit margin is by taking percentage of costs as the base. But if this is done, there will be no account on the capital required / investment made. This is countered by taking the base as “Assets employed”. 2) When taking base as “Assets employed”, if historical costs of assets are used, then it will again affect the metric, as old assets are generally undervalued. This is countered by the company policy, stating that the depreciated book value cannot be less than one-half of the original cost. 3) It is difficult to arrive at the optimal profit objective, as it will be very subjective. This can be countered by keeping the division profit objective as the “Average division profit objective”. General Items: In case of general items which are available in the outside market, Transfer price = out of pocket expenses + opportunity cost Where the opportunity cost is the profit which the division will lose for not selling in the outside market. Opportunity cost (General Item) = Outside Selling Price (Minimum) – Out of pocket expenses The price considered is the lowest price available in the market, with the acceptable quality. This model is called the “market price based transfer price”, as the transfer price is decided by the market forces.
Pros of using “Market price based transfer pricing” method: 1) It is the most simplest and ideal method for transfer pricing 2) It induces Goal Congruence Cons of using “Market price based transfer pricing” method: 1) Sometimes may be difficult to get market prices, if the vendor knows that the intention is not to buy, but just to account for internal transfer. 2) If a company has invested significantly in facilities, it is unlikely to use outside services, unless the outside selling price is less than the company’s variable cost.
Division F:
Division F should be treated as “Cost Center” (Justification is in next section) This division produces about 75% of “Type K” Items: In case of “Cost Center” the division will not include “Profit margin” in its calculation for transfer pricing. Hence transfer pricing for division F shall be Transfer Pricing = Out of pocket expenses (The pros & cons of the decision are explained in the next section)
Other Divisions:
Other divisions which either fabricate less amount of “Type K” items and divisions which assemble intermediate or end items can be continued to be treated as “Profit Centers” and hence Market based transfer pricing for “General Items” and Cost based transfer pricing for “Type K” items can be used.
Q2) Division F: Profit/Investment Center or Cost Center
Arguments for Division F in favour of “Profit/Investment center” 1) 25% of Division F’s produce is available in the market and hence can be sold or bought in the market directly. 2) There will be no inefficiency creeping into the processes, as the division will keep on focusing on profits, either by reduction in costs or by improved selling price. In other words, they will be under constant pressure to improve their competitive performance. 3) The quality & speed of operating decisions may improve because they are being made by managers closest to the point of decision. Arguments against “Profit/Investment Center” 1) There might be an increase in frictions between divisions on argument over “Transfer Price”. An increase in profit for one manager, may mean a decrease in profit for another. Arguments for Division F in favour of “Cost Center” 1) 75% of the produce of the division is of “Type K” item, which doesn’t have a market outside and has to be transferred to internal divisions only. 2) The division’s main objective doesn’t seem to be profit, but to enable the functioning of other divisions. 3) Less than 5% contribution of “Type K” item from Division F in the end items.
4) Centralized divisions will reduce costs on additional management, staff personnel and record keeping. Arguments against Division F as a “Cost Center” 1) There could be lot of inefficiencies creeping into the system, as the division is no more pressurized to make profits. This will result in higher costs. 2) Quality of the output may also take a hit. 3) Decision makings may take a longer time, as every time, head office might have to involve.
Some of the above arguments can be countered by measuring appropriate metrics. The following metrics such as 1) 2) 3) 4) 5) 6) DPMO (defects per million opportunities) Efficiency & Effectiveness No of other division complaints Employee turnover % of wastage in raw materials Change in cost/unit (Month on Month basis) etc
Will keep a control on the in-efficiencies creeping into the system and also will keep a check on the quality.
From the above arguments, it can be inferred that “Division F” should be treated as a “Cost Center” rather than a “Profit/Investment” center.
doc_110757786.docx