1 Introduction One of the principal challenges in operating a decentralized system is to devise a...

1

Introduction

One of the principal challenges in operating a decentralized system

is to devise a satisfactory method of

accounting for the transfer of goods and

services from one profit center to another in

companies that have a significant number of

these transactions

One of the principal challenges in operating a decentralized system

is to devise a satisfactory method of

accounting for the transfer of goods and

services from one profit center to another in

companies that have a significant number of

these transactions

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Objectives of Transfer Pricing

The transfer price should be designed so that it

accomplishes the following objectives :

• It should provide each business unit It should provide each business unit with the relevant information it with the relevant information it needs to determine the optimum needs to determine the optimum trade off between company costs and trade off between company costs and revenue.revenue.

• It should induce goal congruence It should induce goal congruence decisions.decisions.

• It should help measure the economic It should help measure the economic performance of the individual performance of the individual business units.business units.

• The system should be simple to The system should be simple to understand and easy to administer.understand and easy to administer.

The transfer price should be designed so that it

accomplishes the following objectives :

• It should provide each business unit It should provide each business unit with the relevant information it with the relevant information it needs to determine the optimum needs to determine the optimum trade off between company costs and trade off between company costs and revenue.revenue.

• It should induce goal congruence It should induce goal congruence decisions.decisions.

• It should help measure the economic It should help measure the economic performance of the individual performance of the individual business units.business units.

• The system should be simple to The system should be simple to understand and easy to administer.understand and easy to administer.

3

Transfer Pricing Methods

Transfer Price is to refer to the amount used in

accounting for any transfer of goods and

services between responsibility centers.

Transfer Price is to refer to the amount used in

accounting for any transfer of goods and

services between responsibility centers.

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Fundamental PrinciplesThe fundamental principle is that the transfer The fundamental principle is that the transfer

price should be similar to the price that would price should be similar to the price that would be charged if the product were sold to outside be charged if the product were sold to outside customers or purchased from outside vendorscustomers or purchased from outside vendors

When profit centers of a company buy products When profit centers of a company buy products from, and sell to, one another, two decisions from, and sell to, one another, two decisions must be made periodically for each product :must be made periodically for each product :

1.1. Should the company produce the product Should the company produce the product inside the company or purchase it from an inside the company or purchase it from an outside vendor ?. outside vendor ?. This is the sourcing This is the sourcing decision.decision.

2.2. If produced inside, at what price should the If produced inside, at what price should the product be transferred between profit centers product be transferred between profit centers ?. ?. This is the transfer price decision. This is the transfer price decision.

Fundamental PrinciplesThe fundamental principle is that the transfer The fundamental principle is that the transfer

price should be similar to the price that would price should be similar to the price that would be charged if the product were sold to outside be charged if the product were sold to outside customers or purchased from outside vendorscustomers or purchased from outside vendors

When profit centers of a company buy products When profit centers of a company buy products from, and sell to, one another, two decisions from, and sell to, one another, two decisions must be made periodically for each product :must be made periodically for each product :

1.1. Should the company produce the product Should the company produce the product inside the company or purchase it from an inside the company or purchase it from an outside vendor ?. outside vendor ?. This is the sourcing This is the sourcing decision.decision.

2.2. If produced inside, at what price should the If produced inside, at what price should the product be transferred between profit centers product be transferred between profit centers ?. ?. This is the transfer price decision. This is the transfer price decision.

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The Ideal SituationA market price based, transfer price will A market price based, transfer price will

induce goal congruence if all the induce goal congruence if all the conditions listed below exist :conditions listed below exist :

a.a. Competent PeopleCompetent People• Managers should be interested in long Managers should be interested in long

run as well as the short run run as well as the short run performance of their responsibility performance of their responsibility centers.centers.

b. Good Atmosphereb. Good Atmosphere• Managers must regard profitability as Managers must regard profitability as

measured in their income statements, measured in their income statements, as an important goal.as an important goal.

The Ideal SituationA market price based, transfer price will A market price based, transfer price will

induce goal congruence if all the induce goal congruence if all the conditions listed below exist :conditions listed below exist :

a.a. Competent PeopleCompetent People• Managers should be interested in long Managers should be interested in long

run as well as the short run run as well as the short run performance of their responsibility performance of their responsibility centers.centers.

b. Good Atmosphereb. Good Atmosphere• Managers must regard profitability as Managers must regard profitability as

measured in their income statements, measured in their income statements, as an important goal.as an important goal.

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The Ideal Situationc. A Market Pricec. A Market Price• The ideal transfer price is based on a The ideal transfer price is based on a

well established, normal market price well established, normal market price for the identical product being for the identical product being transferred, a market price reflecting transferred, a market price reflecting the same conditions (quantity, quality) the same conditions (quantity, quality) as the product to which the transfer as the product to which the transfer price applies. price applies.

d. Freedom to Sourced. Freedom to Source• Alternatives for sourcing should exist, Alternatives for sourcing should exist,

and managers should be permitted to and managers should be permitted to choose the alternative that is in their choose the alternative that is in their own best interests. own best interests.

The Ideal Situationc. A Market Pricec. A Market Price• The ideal transfer price is based on a The ideal transfer price is based on a

well established, normal market price well established, normal market price for the identical product being for the identical product being transferred, a market price reflecting transferred, a market price reflecting the same conditions (quantity, quality) the same conditions (quantity, quality) as the product to which the transfer as the product to which the transfer price applies. price applies.

d. Freedom to Sourced. Freedom to Source• Alternatives for sourcing should exist, Alternatives for sourcing should exist,

and managers should be permitted to and managers should be permitted to choose the alternative that is in their choose the alternative that is in their own best interests. own best interests.

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The Ideal Situatione. Full Informatione. Full Information• Managers must know about Managers must know about

the available alternatives the available alternatives and the relevant costs and and the relevant costs and revenues of eachrevenues of each

f. Negotiationf. Negotiation• There must be a smoothly There must be a smoothly

working mechanism for working mechanism for negotiating “contracts” negotiating “contracts” between business unitsbetween business units

The Ideal Situatione. Full Informatione. Full Information• Managers must know about Managers must know about

the available alternatives the available alternatives and the relevant costs and and the relevant costs and revenues of eachrevenues of each

f. Negotiationf. Negotiation• There must be a smoothly There must be a smoothly

working mechanism for working mechanism for negotiating “contracts” negotiating “contracts” between business unitsbetween business units

If all of the

conditions are

exist, a transfer

price system

based on market prices would induce goals

congruence

decisions

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Constraints on Constraints on SourcingSourcing

Ideally, the buying Ideally, the buying manager should be free manager should be free to make sourcing to make sourcing decisions. Similarly, the decisions. Similarly, the selling manager should selling manager should be free to sell products be free to sell products in the most in the most advantageous marketadvantageous market

In real life, however, In real life, however, freedom to source might freedom to source might not be feasible or, if it is not be feasible or, if it is feasible, might be feasible, might be constraint by corporate constraint by corporate policy.policy.


Ideally, the buying Ideally, the buying manager should be free manager should be free to make sourcing to make sourcing decisions. Similarly, the decisions. Similarly, the selling manager should selling manager should be free to sell products be free to sell products in the most in the most advantageous marketadvantageous market

In real life, however, In real life, however, freedom to source might freedom to source might not be feasible or, if it is not be feasible or, if it is feasible, might be feasible, might be constraint by corporate constraint by corporate policy.policy.

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Constraints on SourcingConstraints on SourcingLimited MarketLimited MarketIn many companies, markets for the In many companies, markets for the

buying or selling profit centers may be buying or selling profit centers may be limited, because oflimited, because of

• The existence of internal capacity might The existence of internal capacity might limit the development of external sales.limit the development of external sales.

• If a company is the sole producer of a If a company is the sole producer of a differentiated product, no outside differentiated product, no outside source exists.source exists.

• If a company has invested significantly If a company has invested significantly in facilities, it is unlikely to use outside in facilities, it is unlikely to use outside sources unless the outside selling price sources unless the outside selling price approaches the company’s variable approaches the company’s variable cost. cost.

Constraints on SourcingConstraints on SourcingLimited MarketLimited MarketIn many companies, markets for the In many companies, markets for the

buying or selling profit centers may be buying or selling profit centers may be limited, because oflimited, because of

• The existence of internal capacity might The existence of internal capacity might limit the development of external sales.limit the development of external sales.

• If a company is the sole producer of a If a company is the sole producer of a differentiated product, no outside differentiated product, no outside source exists.source exists.

• If a company has invested significantly If a company has invested significantly in facilities, it is unlikely to use outside in facilities, it is unlikely to use outside sources unless the outside selling price sources unless the outside selling price approaches the company’s variable approaches the company’s variable cost. cost.

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Constraints on SourcingConstraints on SourcingHow does a company find out How does a company find out

what the competitive price is what the competitive price is if it does not buy or sell the if it does not buy or sell the product in an outside product in an outside market ?. Here are some market ?. Here are some ways :ways :

If published market prices are If published market prices are available, they can be used to available, they can be used to establish transfer prices.establish transfer prices.

Market prices may be set by Market prices may be set by bids. This generally can be bids. This generally can be done only if the low bidder done only if the low bidder stands a reasonable chance of stands a reasonable chance of obtaining the business. obtaining the business.

Constraints on SourcingConstraints on SourcingHow does a company find out How does a company find out

what the competitive price is what the competitive price is if it does not buy or sell the if it does not buy or sell the product in an outside product in an outside market ?. Here are some market ?. Here are some ways :ways :

If published market prices are If published market prices are available, they can be used to available, they can be used to establish transfer prices.establish transfer prices.

Market prices may be set by Market prices may be set by bids. This generally can be bids. This generally can be done only if the low bidder done only if the low bidder stands a reasonable chance of stands a reasonable chance of obtaining the business. obtaining the business.

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If the production profit If the production profit center sells similar center sells similar products in outside products in outside markets, it is often markets, it is often possible to replicate a possible to replicate a competitive price on the competitive price on the basis of the outside pricebasis of the outside price

If the buying profit center If the buying profit center purchases similar products purchases similar products from the outside market, it from the outside market, it may be possible to may be possible to replicate competitive replicate competitive prices for its proprietary prices for its proprietary products.products.


If the production profit If the production profit center sells similar center sells similar products in outside products in outside markets, it is often markets, it is often possible to replicate a possible to replicate a competitive price on the competitive price on the basis of the outside pricebasis of the outside price

If the buying profit center If the buying profit center purchases similar products purchases similar products from the outside market, it from the outside market, it may be possible to may be possible to replicate competitive replicate competitive prices for its proprietary prices for its proprietary products.products.

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Constraints on SourcingConstraints on SourcingExcess or Shortage of Industry CapacityExcess or Shortage of Industry Capacity Some companies allow either the Some companies allow either the

buying or selling profit center to buying or selling profit center to appeal a sourcing decision to a central appeal a sourcing decision to a central person or committeeperson or committee

If there are constraints on sourcing, If there are constraints on sourcing, the market price is the best transfer the market price is the best transfer price. If the market price exists or can price. If the market price exists or can be approximated, use it.be approximated, use it.

However, if there is no way of However, if there is no way of approximating valid competitive prices, approximating valid competitive prices, the other option is to develop cost the other option is to develop cost based transfer prices. based transfer prices.

Constraints on SourcingConstraints on SourcingExcess or Shortage of Industry CapacityExcess or Shortage of Industry Capacity Some companies allow either the Some companies allow either the

buying or selling profit center to buying or selling profit center to appeal a sourcing decision to a central appeal a sourcing decision to a central person or committeeperson or committee

If there are constraints on sourcing, If there are constraints on sourcing, the market price is the best transfer the market price is the best transfer price. If the market price exists or can price. If the market price exists or can be approximated, use it.be approximated, use it.

However, if there is no way of However, if there is no way of approximating valid competitive prices, approximating valid competitive prices, the other option is to develop cost the other option is to develop cost based transfer prices. based transfer prices.

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Cost Bases Transfer Cost Bases Transfer PricesPrices

If competitive prices are not If competitive prices are not available, transfer prices available, transfer prices may be set on the basis of may be set on the basis of cost plus a profit, even cost plus a profit, even though such transfer prices though such transfer prices may be complex to calculate may be complex to calculate and the results less and the results less satisfactory than a market satisfactory than a market price.price.

The two decisions must be The two decisions must be made in a cost based made in a cost based transfer price system :transfer price system :

a.a. How to define cost How to define cost b.b. How to calculate the profit How to calculate the profit

markup markup


If competitive prices are not If competitive prices are not available, transfer prices available, transfer prices may be set on the basis of may be set on the basis of cost plus a profit, even cost plus a profit, even though such transfer prices though such transfer prices may be complex to calculate may be complex to calculate and the results less and the results less satisfactory than a market satisfactory than a market price.price.

The two decisions must be The two decisions must be made in a cost based made in a cost based transfer price system :transfer price system :

a.a. How to define cost How to define cost b.b. How to calculate the profit How to calculate the profit

markup markup

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Cost Bases Transfer Cost Bases Transfer PricesPricesThe Cost BasisThe Cost BasisThe usual basis is standard The usual basis is standard costs.costs.Actual costs should not be Actual costs should not be used because production used because production inefficiencies will be inefficiencies will be passed on to the buying passed on to the buying profit center. If standard profit center. If standard costs are used, an costs are used, an incentive is needed to set incentive is needed to set tight standards and tight standards and improve standards.improve standards.

Cost Bases Transfer Cost Bases Transfer PricesPricesThe Cost BasisThe Cost BasisThe usual basis is standard The usual basis is standard costs.costs.Actual costs should not be Actual costs should not be used because production used because production inefficiencies will be inefficiencies will be passed on to the buying passed on to the buying profit center. If standard profit center. If standard costs are used, an costs are used, an incentive is needed to set incentive is needed to set tight standards and tight standards and improve standards.improve standards.

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The Profit MarkupThe Profit MarkupIn calculating the profit In calculating the profit

markup, there also are two markup, there also are two decisions :decisions :

a.a. What the profit markup is What the profit markup is based onbased on

b.b. The level of profit allowedThe level of profit allowed

• The simplest and most The simplest and most widely used base is a widely used base is a percentage of costs.percentage of costs.

• A conceptually better base is A conceptually better base is percentage of investment. percentage of investment.


The Profit MarkupThe Profit MarkupIn calculating the profit In calculating the profit

markup, there also are two markup, there also are two decisions :decisions :

a.a. What the profit markup is What the profit markup is based onbased on

b.b. The level of profit allowedThe level of profit allowed

• The simplest and most The simplest and most widely used base is a widely used base is a percentage of costs.percentage of costs.

• A conceptually better base is A conceptually better base is percentage of investment. percentage of investment.

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Upstream Fixed Costs and ProfitsTransfer pricing can create a significant

problem in integrated companies. The profit center that finally sells to the outside customer may not even be aware of the amount of upstream fixed costs and profit included in its internal purchase price. Methods that companies use to mitigate this problem, are :

a. Agreement Among Business Unitsb. Two Step Pricingc. Profit Sharingd. Two Sets of Prices

Upstream Fixed Costs and ProfitsTransfer pricing can create a significant

problem in integrated companies. The profit center that finally sells to the outside customer may not even be aware of the amount of upstream fixed costs and profit included in its internal purchase price. Methods that companies use to mitigate this problem, are :

a. Agreement Among Business Unitsb. Two Step Pricingc. Profit Sharingd. Two Sets of Prices

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Upstream Fixed Costs and Profits a. Agreement Among Business UnitsSome companies establish a Some companies establish a formal mechanism whereby formal mechanism whereby representatives from the representatives from the buying and selling units meet buying and selling units meet periodically to decide on periodically to decide on outside selling prices and the outside selling prices and the sharing of profits for products sharing of profits for products with significant upstream fixed with significant upstream fixed costs and profit costs and profit

Upstream Fixed Costs and Profits a. Agreement Among Business UnitsSome companies establish a Some companies establish a formal mechanism whereby formal mechanism whereby representatives from the representatives from the buying and selling units meet buying and selling units meet periodically to decide on periodically to decide on outside selling prices and the outside selling prices and the sharing of profits for products sharing of profits for products with significant upstream fixed with significant upstream fixed costs and profit costs and profit

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Upstream Fixed Costs and Profits

b. Two Step PricingEstablish a transfer price that Establish a transfer price that

includes two charges :includes two charges :• For each unit sold, a charge For each unit sold, a charge

is made that is equal to the is made that is equal to the standard variable cost of standard variable cost of production.production.

• A periodic charge is made A periodic charge is made that is equal to the fixed that is equal to the fixed costs associated with the costs associated with the facilities reserved for the facilities reserved for the buying unit. buying unit.


b. Two Step PricingEstablish a transfer price that Establish a transfer price that

includes two charges :includes two charges :• For each unit sold, a charge For each unit sold, a charge

is made that is equal to the is made that is equal to the standard variable cost of standard variable cost of production.production.

• A periodic charge is made A periodic charge is made that is equal to the fixed that is equal to the fixed costs associated with the costs associated with the facilities reserved for the facilities reserved for the buying unit. buying unit.

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Business Unit X (manufacturer) Product A

Expected monthly sales to business unit Y Expected monthly sales to business unit Y 5,000 units5,000 units

Variable cost per unit Variable cost per unit $ 5 $ 5

Monthly fixed costs assigned to product Monthly fixed costs assigned to product 20,000 20,000

Investment in working capital and facilities Investment in working capital and facilities 1,200,0001,200,000

Competitive return on investment per year Competitive return on investment per year 10 % 10 %

One way to transfer product A to business unit Y One way to transfer product A to business unit Y is at price per unit, calculated as follows :is at price per unit, calculated as follows :

Transfer price for Transfer price for product Aproduct A

Variable cost per unit $ 5Variable cost per unit $ 5Plus fixed cost per unit $ 4Plus fixed cost per unit $ 4Pus profit per unit Pus profit per unit $ 2$ 2Transfer price per unit $ 11Transfer price per unit $ 11

Business Unit X (manufacturer) Product A

Expected monthly sales to business unit Y Expected monthly sales to business unit Y 5,000 units5,000 units

Variable cost per unit Variable cost per unit $ 5 $ 5

Monthly fixed costs assigned to product Monthly fixed costs assigned to product 20,000 20,000

Investment in working capital and facilities Investment in working capital and facilities 1,200,0001,200,000

Competitive return on investment per year Competitive return on investment per year 10 % 10 %

One way to transfer product A to business unit Y One way to transfer product A to business unit Y is at price per unit, calculated as follows :is at price per unit, calculated as follows :

Transfer price for Transfer price for product Aproduct A

Variable cost per unit $ 5Variable cost per unit $ 5Plus fixed cost per unit $ 4Plus fixed cost per unit $ 4Pus profit per unit Pus profit per unit $ 2$ 2Transfer price per unit $ 11Transfer price per unit $ 11

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Transfer Pricing MethodsCorrection by two step pricing :Transfer price for product “A” $ 5 + $ Transfer price for product “A” $ 5 + $

20,000/month fixed cost + $ 10,000 per month 20,000/month fixed cost + $ 10,000 per month for profit :for profit :

$ 1,200,000 x 0.10$ 1,200,000 x 0.10 = 10,000 = 10,000 1212Unit “Y” will pay the variable cost of Unit “Y” will pay the variable cost of (5,000 unit x $ 5/unit) : $ 25,000 (5,000 unit x $ 5/unit) : $ 25,000 Plus fixed cost and profit : Plus fixed cost and profit : $ 30,000$ 30,000Total $ 55,000Total $ 55,000Unit “X” will pay $ 11/unit (5.000 unit x $ 11 = $ Unit “X” will pay $ 11/unit (5.000 unit x $ 11 = $

55,000)55,000)If transfers in another month were 4,000 units, If transfers in another month were 4,000 units,

Unit “Y” would pay $ 50,000 [(4,000 unit x $ %) Unit “Y” would pay $ 50,000 [(4,000 unit x $ %) + $ 30,000], under two step pricing, compared + $ 30,000], under two step pricing, compared with $ 44,000 ($ 11 x 4,000 unit).with $ 44,000 ($ 11 x 4,000 unit).

The difference is penalty for not using a portion The difference is penalty for not using a portion of unit X’s capacity that it has reserved. of unit X’s capacity that it has reserved.

Correction by two step pricing :Transfer price for product “A” $ 5 + $ Transfer price for product “A” $ 5 + $

20,000/month fixed cost + $ 10,000 per month 20,000/month fixed cost + $ 10,000 per month for profit :for profit :

$ 1,200,000 x 0.10$ 1,200,000 x 0.10 = 10,000 = 10,000 1212Unit “Y” will pay the variable cost of Unit “Y” will pay the variable cost of (5,000 unit x $ 5/unit) : $ 25,000 (5,000 unit x $ 5/unit) : $ 25,000 Plus fixed cost and profit : Plus fixed cost and profit : $ 30,000$ 30,000Total $ 55,000Total $ 55,000Unit “X” will pay $ 11/unit (5.000 unit x $ 11 = $ Unit “X” will pay $ 11/unit (5.000 unit x $ 11 = $

55,000)55,000)If transfers in another month were 4,000 units, If transfers in another month were 4,000 units,

Unit “Y” would pay $ 50,000 [(4,000 unit x $ %) Unit “Y” would pay $ 50,000 [(4,000 unit x $ %) + $ 30,000], under two step pricing, compared + $ 30,000], under two step pricing, compared with $ 44,000 ($ 11 x 4,000 unit).with $ 44,000 ($ 11 x 4,000 unit).

The difference is penalty for not using a portion The difference is penalty for not using a portion of unit X’s capacity that it has reserved. of unit X’s capacity that it has reserved.

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c. Profit SharingThe system operates as follows :The system operates as follows :• The product is transferred to the The product is transferred to the

marketing unit at standard marketing unit at standard variable costvariable cost

• After the product is sold, the After the product is sold, the business units share the business units share the contribution earned, which is the contribution earned, which is the selling price minus the variable selling price minus the variable manufacturing and marketing manufacturing and marketing costs.costs.


c. Profit SharingThe system operates as follows :The system operates as follows :• The product is transferred to the The product is transferred to the

marketing unit at standard marketing unit at standard variable costvariable cost

• After the product is sold, the After the product is sold, the business units share the business units share the contribution earned, which is the contribution earned, which is the selling price minus the variable selling price minus the variable manufacturing and marketing manufacturing and marketing costs.costs.

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Upstream Fixed Costs and Profits d. Two Sets of PricesThe manufacturing unit’s The manufacturing unit’s revenue is credited at the revenue is credited at the outside sales price and outside sales price and the buying unit is the buying unit is charged the total charged the total standard costs. The standard costs. The difference is charged to a difference is charged to a headquarters account headquarters account and eliminated when the and eliminated when the business unit statements business unit statements are consolidated.are consolidated.

Upstream Fixed Costs and Profits d. Two Sets of PricesThe manufacturing unit’s The manufacturing unit’s revenue is credited at the revenue is credited at the outside sales price and outside sales price and the buying unit is the buying unit is charged the total charged the total standard costs. The standard costs. The difference is charged to a difference is charged to a headquarters account headquarters account and eliminated when the and eliminated when the business unit statements business unit statements are consolidated.are consolidated.

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Pricing Corporate Services

There remain two types There remain two types of transfers :of transfers :

1. For central services 1. For central services that the receiving that the receiving unit must accept but unit must accept but can at least partially can at least partially control the amount control the amount used.used.

2. For central services 2. For central services that the business unit that the business unit can decide whether can decide whether or not to use. or not to use.

There remain two types There remain two types of transfers :of transfers :

1. For central services 1. For central services that the receiving that the receiving unit must accept but unit must accept but can at least partially can at least partially control the amount control the amount used.used.

2. For central services 2. For central services that the business unit that the business unit can decide whether can decide whether or not to use. or not to use.

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Control Over Amount of ServiceBusiness unit may be required to use Business unit may be required to use

company staffs for services such as IT company staffs for services such as IT and R&D.and R&D.

There are three schools of thought about There are three schools of thought about such services.such services.

1.1. A business unit should pay the A business unit should pay the standard variable cost of the standard variable cost of the discretionary services.discretionary services.

2.2. A price equal to the standard variable A price equal to the standard variable cost plus a fair share of the standard cost plus a fair share of the standard fixed costs, that is, the full cost.fixed costs, that is, the full cost.

3.3. A price that is equivalent to the A price that is equivalent to the market price or to standard full cost market price or to standard full cost plus a profit margin.plus a profit margin.

Control Over Amount of ServiceBusiness unit may be required to use Business unit may be required to use

company staffs for services such as IT company staffs for services such as IT and R&D.and R&D.

There are three schools of thought about There are three schools of thought about such services.such services.

1.1. A business unit should pay the A business unit should pay the standard variable cost of the standard variable cost of the discretionary services.discretionary services.

2.2. A price equal to the standard variable A price equal to the standard variable cost plus a fair share of the standard cost plus a fair share of the standard fixed costs, that is, the full cost.fixed costs, that is, the full cost.

3.3. A price that is equivalent to the A price that is equivalent to the market price or to standard full cost market price or to standard full cost plus a profit margin.plus a profit margin.

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Optional Use of ServicesIn some cases, In some cases, management may management may decide that business decide that business units can be choose units can be choose whether to use whether to use central service units. central service units. Business units may Business units may procure the service procure the service from outside, develop from outside, develop their own capability, their own capability, or choose not to use or choose not to use the service at all.the service at all.

Optional Use of ServicesIn some cases, In some cases, management may management may decide that business decide that business units can be choose units can be choose whether to use whether to use central service units. central service units. Business units may Business units may procure the service procure the service from outside, develop from outside, develop their own capability, their own capability, or choose not to use or choose not to use the service at all.the service at all.

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Simplicity of the Price Mechanism

The prices charged The prices charged for corporate services for corporate services will not accomplish will not accomplish their intended result their intended result unless the methods of unless the methods of calculating them are calculating them are straightforward straightforward enough for business enough for business unit managers to unit managers to understand them.understand them.

Simplicity of the Price Mechanism

The prices charged The prices charged for corporate services for corporate services will not accomplish will not accomplish their intended result their intended result unless the methods of unless the methods of calculating them are calculating them are straightforward straightforward enough for business enough for business unit managers to unit managers to understand them.understand them.

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Administration of Transfer Prices

NegotiationIn most companies, In most companies, business units negotiate business units negotiate transfer prices with each transfer prices with each other, that is, transfer other, that is, transfer prices are not set by a prices are not set by a central staff group.central staff group.The most important reason The most important reason for this is the belief that for this is the belief that establishing selling prices establishing selling prices and arriving at satisfactory and arriving at satisfactory purchase prices are among purchase prices are among the primary functions of the primary functions of line management. line management.

NegotiationIn most companies, In most companies, business units negotiate business units negotiate transfer prices with each transfer prices with each other, that is, transfer other, that is, transfer prices are not set by a prices are not set by a central staff group.central staff group.The most important reason The most important reason for this is the belief that for this is the belief that establishing selling prices establishing selling prices and arriving at satisfactory and arriving at satisfactory purchase prices are among purchase prices are among the primary functions of the primary functions of line management. line management.

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Arbitration and Conflict ResolutionA procedure should be in place for A procedure should be in place for

arbitrating transfer price disputes. arbitrating transfer price disputes. Example :Example :• Arbitrating is assigned to single Arbitrating is assigned to single

executive.executive.• Set up a committee.Set up a committee.

Usually such a committee will have three Usually such a committee will have three responsibilities :responsibilities :

a.a. Settling transfer price disputesSettling transfer price disputesb.b. Reviewing sourcing changesReviewing sourcing changesc.c. Changing the transfer price rules when Changing the transfer price rules when

appropriate. appropriate.

Arbitration and Conflict ResolutionA procedure should be in place for A procedure should be in place for

arbitrating transfer price disputes. arbitrating transfer price disputes. Example :Example :• Arbitrating is assigned to single Arbitrating is assigned to single

executive.executive.• Set up a committee.Set up a committee.

Usually such a committee will have three Usually such a committee will have three responsibilities :responsibilities :

a.a. Settling transfer price disputesSettling transfer price disputesb.b. Reviewing sourcing changesReviewing sourcing changesc.c. Changing the transfer price rules when Changing the transfer price rules when

appropriate. appropriate.

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Arbitration and Conflict Resolution

Arbitration can be conducted in a Arbitration can be conducted in a number of ways. With a formal number of ways. With a formal system, both parties submit a system, both parties submit a written case to the arbitrator. The written case to the arbitrator. The arbitrator reviews their positions arbitrator reviews their positions and decides on the price.and decides on the price.

There are four ways to resolve There are four ways to resolve conflicts :conflicts :

• ForcingForcing• SmoothingSmoothing• BargainingBargaining• Problem Solving Problem Solving

Arbitration and Conflict Resolution

Arbitration can be conducted in a Arbitration can be conducted in a number of ways. With a formal number of ways. With a formal system, both parties submit a system, both parties submit a written case to the arbitrator. The written case to the arbitrator. The arbitrator reviews their positions arbitrator reviews their positions and decides on the price.and decides on the price.

There are four ways to resolve There are four ways to resolve conflicts :conflicts :

• ForcingForcing• SmoothingSmoothing• BargainingBargaining• Problem Solving Problem Solving

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Product ClassificationThe extent and formality of the sourcing The extent and formality of the sourcing

and transfer pricing rules depend to a and transfer pricing rules depend to a large extent on the number of intra large extent on the number of intra company transfers and the availability company transfers and the availability of markets and market prices.of markets and market prices.

Some companies divide products into two Some companies divide products into two main classes :main classes :

• Classes I, includes all products for Classes I, includes all products for which senior management wishes to which senior management wishes to control sourcingcontrol sourcing

• Classes II, is all other products. In Classes II, is all other products. In general, these are products that can be general, these are products that can be produced outside the company without produced outside the company without any significant disruption to present any significant disruption to present operations. operations.

Product ClassificationThe extent and formality of the sourcing The extent and formality of the sourcing

and transfer pricing rules depend to a and transfer pricing rules depend to a large extent on the number of intra large extent on the number of intra company transfers and the availability company transfers and the availability of markets and market prices.of markets and market prices.

Some companies divide products into two Some companies divide products into two main classes :main classes :

• Classes I, includes all products for Classes I, includes all products for which senior management wishes to which senior management wishes to control sourcingcontrol sourcing

• Classes II, is all other products. In Classes II, is all other products. In general, these are products that can be general, these are products that can be produced outside the company without produced outside the company without any significant disruption to present any significant disruption to present operations. operations.

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General Considerations

Conditions for Delegating Profit Responsibility

Before delegate expense/revenue Before delegate expense/revenue trade off decision to a lower level trade off decision to a lower level manager, two conditions should manager, two conditions should exists :exists :

a.a. The manager should have access to The manager should have access to the relevant information needed for the relevant information needed for making such a decisionmaking such a decision

b.b. There should be some way to There should be some way to measure the effectiveness of the measure the effectiveness of the trade offs the manager has madetrade offs the manager has made





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Advantages of Profit Centers• The quality of decisions may improve The quality of decisions may improve

because they are being made by because they are being made by managers closest to the point of managers closest to the point of decision.decision.

• The speed of operating decisions may The speed of operating decisions may be increased since they do not have to be increased since they do not have to be referred to corporate headquarters.be referred to corporate headquarters.

• Headquarters management, relieved of Headquarters management, relieved of day to day decision making, can day to day decision making, can concentrate on broader issues.concentrate on broader issues.

• Managers, subject to fewer corporate Managers, subject to fewer corporate restraints, are freer to use their restraints, are freer to use their imagination and initiative.imagination and initiative.

Advantages of Profit Centers• The quality of decisions may improve The quality of decisions may improve

because they are being made by because they are being made by managers closest to the point of managers closest to the point of decision.decision.

• The speed of operating decisions may The speed of operating decisions may be increased since they do not have to be increased since they do not have to be referred to corporate headquarters.be referred to corporate headquarters.

• Headquarters management, relieved of Headquarters management, relieved of day to day decision making, can day to day decision making, can concentrate on broader issues.concentrate on broader issues.

• Managers, subject to fewer corporate Managers, subject to fewer corporate restraints, are freer to use their restraints, are freer to use their imagination and initiative.imagination and initiative.

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Advantages of Profit Centers• Profit centers provide an excellent Profit centers provide an excellent

training ground for general training ground for general management.management.

• Profit consciousness is enhanced since Profit consciousness is enhanced since managers who are responsible for managers who are responsible for profits will constantly seek ways to profits will constantly seek ways to increase them. increase them.

• Provide top management with ready Provide top management with ready made information on the profitability of made information on the profitability of the company’s individual components.the company’s individual components.

• Because their output is so readily Because their output is so readily measured, profit centers are measured, profit centers are particularly responsive to pressures to particularly responsive to pressures to improve their competitive performance. improve their competitive performance.

Advantages of Profit Centers• Profit centers provide an excellent Profit centers provide an excellent

training ground for general training ground for general management.management.

• Profit consciousness is enhanced since Profit consciousness is enhanced since managers who are responsible for managers who are responsible for profits will constantly seek ways to profits will constantly seek ways to increase them. increase them.

• Provide top management with ready Provide top management with ready made information on the profitability of made information on the profitability of the company’s individual components.the company’s individual components.

• Because their output is so readily Because their output is so readily measured, profit centers are measured, profit centers are particularly responsive to pressures to particularly responsive to pressures to improve their competitive performance. improve their competitive performance.

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Example• ABB (Asea Brown Boveri), a european ABB (Asea Brown Boveri), a european

multinational in the business of power multinational in the business of power generation, transmission and generation, transmission and distribution, was organized into 4,500 distribution, was organized into 4,500 small profit centers, each with profit small profit centers, each with profit and loss responsibility and meaningful and loss responsibility and meaningful autonomy.autonomy.

• Many Japanese companies use profit Many Japanese companies use profit centers. The Kyocera Corporation, a centers. The Kyocera Corporation, a technology company, divided itself into technology company, divided itself into 800 small companies (nicknamed 800 small companies (nicknamed amoeba), which were expected to trade amoeba), which were expected to trade both internally and externally both internally and externally

Example• ABB (Asea Brown Boveri), a european ABB (Asea Brown Boveri), a european

multinational in the business of power multinational in the business of power generation, transmission and generation, transmission and distribution, was organized into 4,500 distribution, was organized into 4,500 small profit centers, each with profit small profit centers, each with profit and loss responsibility and meaningful and loss responsibility and meaningful autonomy.autonomy.

• Many Japanese companies use profit Many Japanese companies use profit centers. The Kyocera Corporation, a centers. The Kyocera Corporation, a technology company, divided itself into technology company, divided itself into 800 small companies (nicknamed 800 small companies (nicknamed amoeba), which were expected to trade amoeba), which were expected to trade both internally and externally both internally and externally

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Difficulties with Profit CentersDifficulties with Profit Centers Decentralized decision making will Decentralized decision making will

force top management to rely more on force top management to rely more on management control reports than on management control reports than on personal knowledge of an operation.personal knowledge of an operation.

If headquarters management is more If headquarters management is more capable than the average profit center capable than the average profit center manager, the quality of decisions made manager, the quality of decisions made at the unit level may be reduced.at the unit level may be reduced.

Friction may increase of arguments Friction may increase of arguments over the appropriate transfer price.over the appropriate transfer price.

Competent general managers may not Competent general managers may not exist in a functional organizationexist in a functional organization

Difficulties with Profit CentersDifficulties with Profit Centers Decentralized decision making will Decentralized decision making will

force top management to rely more on force top management to rely more on management control reports than on management control reports than on personal knowledge of an operation.personal knowledge of an operation.

If headquarters management is more If headquarters management is more capable than the average profit center capable than the average profit center manager, the quality of decisions made manager, the quality of decisions made at the unit level may be reduced.at the unit level may be reduced.

Friction may increase of arguments Friction may increase of arguments over the appropriate transfer price.over the appropriate transfer price.

Competent general managers may not Competent general managers may not exist in a functional organizationexist in a functional organization

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General ConsiderationsDifficulties with Profit CentersDifficulties with Profit Centers Organization units that once cooperated Organization units that once cooperated

as functional units may now be in as functional units may now be in competition with one another. competition with one another.

Divisionalization may impose additional Divisionalization may impose additional costs because of the additional costs because of the additional management, staff personnel etc.management, staff personnel etc.

There is no completely satisfactory There is no completely satisfactory system for ensuring that optimizing the system for ensuring that optimizing the profits of each individual profit center profits of each individual profit center will optimize the profits of the company will optimize the profits of the company as a whole.as a whole.

There may be too much emphasis on There may be too much emphasis on short run profitability at the expense of short run profitability at the expense of long run profitability.long run profitability.

Difficulties with Profit CentersDifficulties with Profit Centers Organization units that once cooperated Organization units that once cooperated

as functional units may now be in as functional units may now be in competition with one another. competition with one another.

Divisionalization may impose additional Divisionalization may impose additional costs because of the additional costs because of the additional management, staff personnel etc.management, staff personnel etc.

There is no completely satisfactory There is no completely satisfactory system for ensuring that optimizing the system for ensuring that optimizing the profits of each individual profit center profits of each individual profit center will optimize the profits of the company will optimize the profits of the company as a whole.as a whole.

There may be too much emphasis on There may be too much emphasis on short run profitability at the expense of short run profitability at the expense of long run profitability.long run profitability.

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Business Unit as Profit Centers

Most business units are created as profit centers since managers in charge of such units typically control product development, manufacturing and marketing resources.

Most business units are created as profit centers since managers in charge of such units typically control product development, manufacturing and marketing resources.

1 Introduction One of the principal challenges in operating a decentralized system is to devise a...

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Transcript of 1 Introduction One of the principal challenges in operating a decentralized system is to devise a...