Imperial College Business School, London

18th December 2014

Group Assignment
Management Accounting

Submitted to:
Professor Jeremy Fernando

Submitted by:
Group E, Stream 2
Alaine Sung | Hadrien Jacomino | Mokhtar Ibrahim |
Nikhil Gangwani | Ronami Ogulu | Yana Kim

PROBLEM 1
Q1 What, if anything, should John Powell do about Frank Duffys reluctance to use
KEA-priced linerboard manufactured by a Del Norte Paper Company mill in the
United States?
Answer 1:
Transfer pricing: is the setting of the price for goods and services sold between
controlled (or related) legal entities within an enterprise. Hence, the major role of the
management accounting system is to assign a dollar figure to transactions between
different responsibility centers.
Purposes: The main purpose is to induce optimal decision-making in a decentralized
organization (i.e., to maximize the profit of the entire organization). However, there
are other reasons such as;

Creating independent profit figures for each division and thus assessing the
performance of each division distinctly.

Assist with the synchronization of production, sales and pricing decisions of

the various divisions (through the use of suitable transfer prices). Further,
these prices alert the managers to the value that goods and services have for
other segments of the firm.

Not only will the transfer price have a significant effect on the reported profit
of each profit center, additionally, it will influence the allocation of an
organizations resources.

Mechanics:

Unnecessary of physical money to be exchanged between the two divisions.

This price is solely for in-house records.

The results of the formula (Transfer Price quantity of goods exchanged), acts
as an expense for the purchasing division center and a revenue for the selling
division.

Del Norte Paper Company is a fully integrated paper manufacturer. This case
primarily involves transfer pricing amongst:
DNP Paper Mill
International subsidiaries
o DNP Italia
o DNP Deutschland.

Del Norte Paper Company is fully integrated paper manufacturer. This case is
primarily involves transfer pricing amongst:
DNP Paper Mill
International subsidiaries
o DNP Italia
o DNP Deutschland.
The following Figure 1.1 describes the situation as given in the case study:

Figure 1.1

The bids are placed by 22 companies in the range of $340-$550, with most of
them within 5% of $400 per ton.
DNP Italia places the winning bet of $400 by using the SPOT market cost estimate
of linerboard ($220/ton).
DNP Deutschland places the bet of $550 by using DNP Paper-Mill cost estimate
of linerboard as ($360/ton)
Criteria for winning the bet: Lowest bid from a firm viewed, as being capable of
meeting the customers desired delivery and quality standards

The following table illustrates the analysis for the bids placed by the
two subsidiaries:

Table 1.1

* The cost of linerboard per ton of corrugated box sold is $235. The actual cost per
ton of linerboard used is $220. Thus the relevant conversion ratio is (235/220) = 1.07
Pricing for Del Norte Porte Paper Mill Linerboard:

Table 1.2

* $385 represents the linerboard cost per ton of corrugated box sold. The actual cost
per ton of linerboard used was $360. Thus the relevant ratio is (385/360)=1,07

Table 1.3

In this case we assume that both DNP Italia and DNP Deutschland place a bid of $400
for the African sale, and then further analyse the profit contribution to DNP in all the
4 cases. The conclusion we have from this is that DNP Deutschland is more efficient
as a company because their conversion cost is lesser ($75) as compared to DNP
Italias conversion cost ($90).
DNP Deutschland could have added more contribution to the company if they would
have bought from the Spot Market and placed a bid of $400. Also analyzing the two
situations it is clear that it is more profitable to buy from the spot market because of
the lower prices and thus that adds more contribution to the company.

Case 1: Contribution comparison when DNP buys from DNP Paper Mill
In this case we assume that in order to win the bid, DNP Italia still places the bid of
$400 and buys craft linerboard at $360/ton form DNP Company Mill in the United
States, and John Powell agrees to transfer the profit to DNP Italia. So the contribution
in both the cases are:

Figure 1.2

Case 2: Tax Avoidance

If Tax Rate Italy > Tax Rate Americas (significantly) then John Powell
should motivate Frank Duffy to buy from DNP Company Paper Mill,
because then the company will have greater after tax contribution.
The following hypothetical example illustrates it:
Tax rate Italy = 40%
Tax Rate Americas = 0%

Table 1.4

Thus, if based on the taxation rate, if they use KEA-price DNP linerboard they will be
able to avoid tax because the cost of goods sold will be very high, and the profit
margin will be in negative, thus they will not pay any taxes, and the net contribution
to the company will be ($134 - $45) $89 which is significantly greater than $45.

*This conclusion is specific to assumption where Tax rate Italy > Tax Rate Americas

Case 3: DNP Paper Mill doesnt have excess capacity (Opportunity Cost)
The case study mentions that DNP Paper mill can only cater to 35-40% of the
capacity of the demand by international subsidiaries. In this case, if DNP Italia buys
from KEA-priced DNP Paper Mill and places a bid of $400, the net contribution to
the company is $59 as compared to $133 if DNP Paper Mill sells it to international
customers outside the company at $360/ton.

Table 1.5

Thus because there is not excess capacity, DNP Company Mill can sell linerboard at
KEA-set price i.e. $360/ton and make more contribution rather than transferring it to
DNP Italia. There is an opportunity cost of $75, which DNP loses if DNP Italia buys
from DNP Paper Mill to sell it at a price of $400.

Case 4: Price Stability | Cheaper price in normal economic conditions

In the long run (normal economic conditions), the KEA-priced DNP linerboard will
cost the company less as compared to spot market linerboard. Thus, if DNP Italia buys
from DNP Company Mill, they have two advantages in the long run:
1. Help Maintain price stability with KEA
2. Relatively lesser cost for cost for linerboard in normal economic conditions
3. Also linerboard produced in DNP Company Mill in Americas is of better quality
as compared to linerboard produced internationally.
Along with stable pricing and lesser costs, this will encourage international trade
between the DNP Company Mill and its international subsidiaries, making long-term
commitments, which will benefit both in the long run.
There are further two cases attached to it:
Short Term Scenario
Thus even if they transfer the profit to
DNP Italia when they use supply from
DNP Company Paper Mill, it is lesser
than the contribution if DNP buys
linerboard form spot market. Thus by
buying from the spot market, DNP makes
more profit as compared if they sell
linerboard from their own mill in
Americas.

Long Term Scenario

In the long term John Powell should push
Frank Duffy of DNP Italia to use KEApriced linerboard, because:
1. Maintains Price Stability
2. Lower Costs in long run
3. Better Quality of linerboard

Thus John Powell should motivate Frank

Duffy to buy from DNP Company Mill in
John Powell should let DNP Italia buy the long run.
from spot market as it adds more
contribution to the firm.

Case 5: Role of Labour Unions in Italy

Labour unions in Italy are rather powerful and strong, making it impossible for Frank
Duffy to keep the plants idle and fire employees. So in order to prevent that Frank
Duffy has to place a competitive bids and win contracts in order keep the employees
busy. With respect to African Sale, they need to maintain a low bid level and be
profitable, which only leaves Frank Duffy with an option to bid from Spot Market and
thus keep the bid price competitive and keep the division profitable.
John Powell can motivate Frank Duffy to agree to buy from DNP Company mill
because if they end up losing the bid, unlike U.S. they cannot fire the workers so
easily.

Conclusion
John Powell can only encourage Frank Duffy to buy from DNP company mills at the
KEA-price only in very specific cases (when Tax is lower in America then in Italy; to
maintain price stability) given the current transfer pricing policy. The policy right now
is very ambiguous and doesnt send across a clear aim/objective to the decision
maker. John Powell needs to review the policy and make sure it has an objective for
goal congruence. Thus in the above cases, there are very few situations when John
Powell will actually encourage/impose Frank Duffy to buy from DNP U.S. Mills
because of the net contribution transfer to the company.
In all the other cases its better for the company as a whole when DNP Italia buys from
the Spot Market, as the contribution is much higher w.r.t. the contribution when it
buys from the U.S. company mill. Based on the above cases Frank Duffy and John
Powell will both be more inclined to buy from the spot market because of higher
contribution, and in the rest of cases it depends on assumptions (e.g. tax rates).

PROBLEM 2
Q2. Given the specific situation illustrated by this case, is a review of the overall
transfer pricing policy of DNP called for? If so, what changes would you
recommend?
Answer 2:
The transfer policy of DNP requires certainly needs to be reviewed in order for it to
be more effective.
An effective transfer pricing policy is able to is able to meet the following objectives:

Greater Divisional Autonomy

Greater Motivation for managers
Better performance evaluation
Better goal congruence

Less Taxes, duties and tariffs

Less foreign exchange risks
Better competitive position
Better governmental relations

DNPs transfer policy isnt the most efficient, and for that we can suggest certain
proposals:

1: Structured Cash Flow | Functions of Profit Center

DNPs transfer pricing policy is not at all efficient because it doesnt motivate DNP Italias
Manager Frank Duffy to buy from them. A profit center is supposed to have its costs and
revenues, but in this case they only cater to costs and the profits are never credited back to the
subsidiaries account. This demotivates them because, their aim is to make profits, but because
of transfer pricing policy they end up losses.
The only effective solution to tackle this problem is to actually transfer the profits from
internal transfer of goods to the subsidiaries account. By this, the international subsidiaries
stay motivated to buy goods from within the company and are able to contribute to the overall
profits of the company.

2: Structure of DNP | Division of Power Centralised/Decentralised

DNP needs to refine its structure and allocate power amongst its subsidiaries
rationally. They should define the structure of DNP as either centralized or
decentralized so that the decision maker has clarity of thought. Currently the structure
is not very clear, and also the decision making power is rather ambiguous. The
international subsidiary managers do not have clear authority about their power, and
the headquarters also take part in the decision making process. International
subsidiaries might/might not act in the favour of the company because of unclear
division and power, and structure of the company.

3: Long-term contract with DNP Company Paper Mill (Price Stability)

In order to make transfer pricing policy more efficient, DNPs international
subsidiaries should enter into long term contract with DNP Company Mill so that they
have a stable price for the linerboard. Currently, its a recession and therefore
Price Spot < Price KEA. In normal economic conditions and condition of boom its the
opposite and Price KEA < Price Spot (like it happened previously).
Secondly, DNP Paper Mill has limited capacity, and therefore if the international
subsidiaries enter into long-term contracts, they will not have to face any shortages.
Thus purchasing from DNP U.S. Paper Mills can minimize price volatility, ensure
constant supply of linerboard, ensuring access to lower prices in conditions of boom
and add to the contributions of the company as a whole. It will also help in developing
close relationships between the subsidiaries and the companys mills, which will
eventually help the company as a whole with the overall profitability.

Overall decision for the Transfer Pricing Policy

In conclusion, the above three changes should be implemented when the transfer
policy is reviewed. Firstly, It is very important for the company to have a clear
structure and objective. The international subsidiaries need to be clarified about their
authority and decision making power so that their decisions are not in conflict with
the company.
Secondly, their needs to be a structure for the cash flow in place, currently the profit
centers have costs but the revenues (profits) are not transferred to them and just
written in a secret book. If they dont earn any profits even after buying from their
own mills, they will not have any motivation to buy from them. This defeats the
whole purpose of being a profit center and discourages the international subsidiary
managers like Frank Duffy to buy from DNP U.S. Mills.
Thirdly, with the transfer policy in place the international subsidiaries should aim to
get into long-term contracts with DNP U.S. Mill. This leads to reduction in price
volatility, ensured supply of linerboard and better leads to a better goal congruence
and develops close relationships within the company.