Transfer Pricing/Strategy

Case 18-2Presented by: Group 3Nidhi 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 MethodTransfer price = variable cost of selling unit + markup

Full cost MethodTransfer price = Variable Cost + allocated fixed cost

Market Price MethodTransfer price = current price for the selling unit’s in the

market Negotiated price method

Choosing the Right Transfer Price

Is there an outside supplier? Is the seller’s 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 EXTERNAL FOREIGN

Diamond

Wales Company

Variable Cost = $600+$500 =$1,100

Price = $400

London Company

Price = $1,500

Bayside

Cole Price = $1,250

Price = $600

Cole Division

Diamond division

Cole Division

price= $1,100 or $1,500

Further processing variable cost- $500

Wales company

Further processing variable cost- $400

?price $1,250

Bayside division3,500 Units, var cost $250 per unit

Price =$600

3,000 Units, var cost $300 per unit

Internal to the firm External to the firm

Price = $500

Diamond Division

Diamond division

Diamond Division

3,000 Units

Further processing variable cost- $500

Bayside division

Price =$600

Variable cost - $300

Cole Division London Company

London company

3,000 Units, price- $1,500

Price= $400

Variable cost-$200

Cole Division

If there is an outside supply ----Yes.Is the seller’s 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

Cole Division Bayside TotalSales ( $1,500, $600) $1,500 $600 $2,100Less: Variable Costs

component cost # $600 $600

processing cost # $500 $300 $800Contribution Margin/ Unit $400 $300 $700Total Contribution Margin $1,200,000 $900,000 $2,100,000

Option -1Cole Division Sells to Diamond Division

Contribution Income Statement -3,000 units

Cole Division

Bayside supplying to

Cole

Bayside supplying to

London TotalSales ( $1250, $500, $400) $1,250 $500 $343Less: Variable Costs $500 component cost ## $500 $821

processing cost ## $400 $250 $171 $771Contribution Margin/Unit $350 $250 $171 $771Total Contribution Margin $1,225,000 $875,000 $600,000 $2,700,000

Contribution Income Statement -3,500 units

Cole division Sells to Outside Firm ( Wales)Option -2

Transfer Pricing

The firm benefits more from Option 2.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 Supplier’s 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 Management1. System that encourages decisions consistent with long-run

profitability

• Encourage actions that benefits the overall company’s profitability

2. Allows managers to distinguish costs relevant for short-run decisions

3. Transfer prices could be used to support decisions in both marketing and operating divisions, including:

Marketing Operations- Product Mix - Inventory levels- New Product Introduction - Batch sizes- Product deletion - Process Improvements- Pricing - Capacity management

- Outsourcing: make vs. buy

Q2. What Everyone Wanted

Division Managers1. Transfer prices would report the financial performance of their divisions

fairly

2. 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

4. The system must anticipate that division managers would examine the method and take actions that maximized the reported performance of their divisions

Q2. What Everyone Wanted

Financial Staff1. Credible and reliable information for decision making at all levels of the

organization without excessive arguments and controversy

2. System that is clear, easy to explain, and easy to use

• Updates should be easy

• Components of the transfer price calculation should promote good understanding of the underlying factors driving costs

3. 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 Teva’s 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. First decided to implement ABC in its largest production plant

2. 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

3. Originally the ABC models were retrospective

• Calculating the activities costs, activity cost driver rates, and product costs for the prior year

4. 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

Marketing Division

Unit CostsBatchCosts

Product Specific

PlantLevel

Cost Pools

• Charges based on actual quantities of each individual products acquire

• Materials and labor

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

• Charges based on budgeted numbers

• No individual product is sold to more than one marketing division

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

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

• Includes cost of raw materials, packaging materials, and direct wages paid to production workers

2. 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. Product sustaining costs – expenses incurred in registering the products, making changes to a product’s production processes, and designing the package

4. 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. Enables product costs to be calculated in a predictable manner throughout the year

2. Eliminates fluctuations in product costs caused by variations in actual spending, resource usage, and activity levels

3. 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. Assigns unit and batch-level costs

2. 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

Figure 1 Structure of Costs in Plants A and B

Plant A Plant BUnit Based Cost 42% 45%Batched Based Cost 32% 30%Product Based Cost 20% 23%Plant Based Cost 6% 2%

• Plant A has a relatively inflexible (high capital intensive) cost structure with high percentage of plant-level costs and low percentage of unit cost – plant most appropriate for high-volume production

•Plant B is much more flexible and is appropriate for small batch sizes and test runs of newly introduced products

Q5. Benefits of ABC - Unused Capacity

Unused capacity occurs in two ways

1. Declines in demand for products manufactured on an existing line

2. 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.

Table 1. Pain Reliever10 Tablets, 250 mg.

Annual Sales 1996 - $2.1 Million

ABC Cost per PackageMaterials use $1.50Production costs $2.10Total $3.60

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

Production Cost Analysis

ResourcesSalaries $0.86Energy $0.27Utilities $0.34Depreciation $0.41Administrative $0.22Total $2.10

Main ActivitiesStorage $0.25Manufacturing $0.61Packaging $0.71Q.A. $0.42Logistics $0.11Total $2.10

Cost DriversNumber of materials $0.55Batches $0.24Labor hours $0.71Machine hours $0.47Samples $0.13Total $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. A pro-rata share of the batch cost of production setup

2. 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

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

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

mixing packing

mixing packing

Table 3. Monthly Debit – May 1995

From Plant A to Local Market Division

Unit Based Batched Based TotalQuantity Material Costs Costs Costs *

Product Produced (per Package) (per Package) (per Package) (per Package) Total Debit **

Pain Reliever 1,000,000 $2.10 $0.22 $0.41 $2.73 $2,730,00020 tablets, 500mg.

Pain Reliever 1,200,000 $1.60 $0.20 $0.32 $2.12 $2,544,00030 Capsules

Syrup 200 cc. 200,000 $0.81 $0.43 $0.11 $1.35 $270,000l ll ll 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 - 1995From Plant A to Local Market Division

Annual Product Plant Based TotalBudgeted Based Costs Costs Costs *

Product Quantity (per Package) (per Package) (per Package) Total Debit **

Pain Reliever 12,000,000 $0.10 $0.21 $0.31 $3,720,00020 tablets, 500mg.

Pain Reliever 20,000,000 $0.12 $0.20 $0.32 $6,400,00030 Capsules

Syrup 200 cc. 3,500,000 $0.14 $0.12 $0.26 $910,000l ll ll l

Cost of used capacity $141,900,000Cost of unused capacity $1,300,000Total $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

Sales revenue $50

Marketing ExpensesUSA Lemmon division $10Local market division $9Other export division $0Total $19

Manufacturing ExpensesPlant A $11Plant B $0Plant C $9Plant D $0Total $20

Total Expenses $39

Profit $11

• 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