Transfer Pricing/Strategy

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

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

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

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?

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

Robert Products Inc.

INTERNAL TO THE FIRM
Bayside

EXTERNAL FOREIGN

Cole

Wales Company

Diamond

London Company Price = $1,500

Cole Division
Internal to the firm
3,000 Units, var cost $300 per unit Price =$600 Further processing variable cost- $500 Bayside division

External to the firm

3,500 Units, var cost $250 per unit

Price = $500 Further processing variable cost- $400

Cole Division

price= $1,100 or $1,500

Diamond division

price $1,250

?
Wales company

Diamond Division
Cole Division
Variable cost - $300 Bayside division

London Company
Variable cost-$200 Price= $400

Price =$600

Further processing variable cost- $500

Diamond division

London company

3,000 Units

3,000 Units, price- $1,500

Diamond Division

Cole Division
If there is an outside supply ----Yes. Is the sellers variable costs < outside price? Yes. Does seller have excess capacity? No. If contribution from outside purchase > contribution from inside purchase . . . Decision to Transfer: Sell outside.

Transfer Pricing
Option -1 Cole Division Sells to Diamond Division Contribution Income Statement -3,000 units

Cole Division
Sales ( $1,500, $600) Less: Variable Costs component cost $1,500 # $600 $500 $400 $1,200,000

Bayside
$600

Total
$2,100 $600

processing cost # Contribution Margin/Unit Total Contribution Margin

$300 $300 $900,000

$800 $700 $2,100,000

Transfer Pricing
Option -2 Cole division Sells to Outside Firm ( Wales) Contribution Income Statement -3,500 units
Cole Division $1,250 ## $500 $250 $250 $875,000 $171 $171 $600,000 Bayside supplying to Cole $500 Bayside supplying to London $343

Total $500 $821 $771 $771 $2,700,000

Sales ( $1250, $500, $400) Less: Variable Costs component cost

processing cost ## $400 Contribution Margin/Unit $350 Total Contribution Margin $1,225,000

The firm benefits more from Option 2.

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

Transfer Pricing with ABC

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

Q2. What Everyone Wanted

Senior Management
1. System that encourages decisions consistent with long-run profitability
2. 3. 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:
Marketing - Product Mix - New Product Introduction - Product deletion - Pricing Operations - Inventory levels - Batch sizes - Process Improvements - Capacity management - Outsourcing: make vs. buy

Q2. What Everyone Wanted

Division Managers
1.
2.

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

3.

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

4.

Q2. What Everyone Wanted

Financial Staff
1.
2.

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

3.

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

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

Q3. Why did ABC work?

1. 2. 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 4. Calculating the activities costs, activity cost driver rates, and product costs for the prior year

3.

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

5.

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

Q4. Using ABC costs for Transfer Pricing

Manufacturing Plants

Cost Pools
Unit Costs
Batch Costs
Charged for actual number of production and packaging batches of each product order

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

Plant Level
Based on the budgeted use of the capacity of the 4 manufacturing facilities

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

Marketing Division

Q4. The ABC Transfer Price Model Structure

ABC hierarchical structure of unit, batch, product sustaining and plant-level costs 1. Unit Level Costs direct expenses associated with producing individual product units such as tablets, capsules, and ampoules 2. 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

3.
4.

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

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 1. 2. 3. 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

1.
2.

Assigns unit and batch-level costs

Product-specific and plant-level costs

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 Figure 1 Structure of Costs in Plants A and B intensive) cost structure with high percentage of plantlevel costs and low percentage of unit cost plant most Plant A Plant B appropriate for high-volume production Unit Based Cost 42% 45% Plant B is much more flexible and is appropriate for small batch sizes and test runs of newly introduced products
Batched Based Cost Product Based Cost Plant Based Cost 32% 20% 6% 30% 23% 2%

Q5. Benefits of ABC - Unused Capacity

Unused capacity occurs in two ways 1. 2. 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.

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

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

Table 1. Pain Reliever 10 Tablets, 250 mg.

Table 1.

Annual Sales 1996 - $2.1 Million

ABC Cost per Package Materials use Production costs Total

$1.50 $2.10 $3.60

(Traditional production costs per package were only $1.50, 40% difference)

Production Cost Analysis Resources Salaries Energy Utilities Depreciation Administrative Total Main Activities Storage Manufacturing Packaging Q.A. Logistics Total Cost Drivers Number of materials Batches Labor hours Machine hours Samples Total $0.86 $0.27 $0.34 $0.41 $0.22 $2.10 $0.25 $0.61 $0.71 $0.42 $0.11 $2.10 $0.55 $0.24 $0.71 $0.47 $0.13 $2.10

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

1. 2. A pro-rata share of the batch cost of production setup The full batch cost of the packaging setup

Produce a full batch of 6,000 bottles of 100 ml syrup for a large order from a customer in a local market

[$300/6,000] + [$500/6,000] = $.05 + $.083 = $1.33/bottle

mixing packing

Produce a small order of 1,000 bottles of 100 ml syrup, packed in special boxes, for a special tender in S. America

[$300/6,000] + [$500/1,000] = $.05 + $.50 = $0.55/bottle

mixing packing

Produce a full batch of 12,000 bottles of 50 ml syrup for a large oder from a customer in the local market

[$300/12,000] + [$500/12,000] = $.025 + $.043 = $0.67/bottle

mixing packing

Table 3. Monthly Debit May 1995

From Plant A to Local Market Division Unit Based Costs
(per Package)

Product Pain Reliever 20 tablets, 500mg. Pain Reliever 30 Capsules Syrup 200 cc.
l l l

Quantity Produced 1,000,000

Material
(per Package)

Batched Based Costs

(per Package)

Total Costs *
(per Package)

Total Debit ** $2,730,000

$2.10

$0.22

$0.41

$2.73

1,200,000

$1.60

$0.20

$0.32

$2.12

$2,544,000

200,000

$0.81

$0.43

$0.11

$1.35

$270,000
l l l

Total

$15,100,200

* Total costs = material + unit based costs = batch based costs ** Total debit = total costs per package x quantity produced

Table 4. Annual Debit - 1995

From Plant A to Local Market Division Annual Budgeted Quantity 12,000,000 Product Based Costs
(per Package)

Plant Based Costs

(per Package)

Total Costs *
(per Package)

Product Pain Reliever 20 tablets, 500mg. Pain Reliever 30 Capsules Syrup 200 cc.
l l l

Total Debit ** $3,720,000

$0.10

$0.21

$0.31

20,000,000

$0.12

$0.20

$0.32

$6,400,000

3,500,000

$0.14

$0.12

$0.26

$910,000
l l l

Cost of used capacity Cost of unused capacity Total

$141,900,000 $1,300,000 $143,200,000

* Total costs = product based costs + plant based costs ** Total debit = total costs per package x annual budgeted quantity

Table 5. 10 Leading Products

Segment A: 1995

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

Sales revenue Marketing Expenses USA Lemmon division Local market division Other export division Total Manufacturing Expenses Plant A Plant B Plant C Plant D Total Total Expenses Profit

$50

$10 $9 $0 $19

$11 $0 $9 $0 $20 $39 $11