- Freedom to source, alternatives for sourcing should exist and managers its own profit to optimize company profit.
imize company profit. Methods that companies use to
should be permitted to choose alternative that is in their own best
interests. Market establishes TP. From company point of view, relevant cost
of product is the market price, the TP represents opportunity cost to the
company.
- Full information, managers must know available alternatives and relevant
costs and revenues of each
- Negotiation, there has to be a smoothly working mechanism for
negotiating ‘contracts’ between business units.
If those conditions are met, TP based on market prices would induce goal-
congruent decisions.
4. Constraints on sourcing — profit centre managers may NOT have the
freedom to make sourcing decisions and implication of constraints on
sourcing appropriate TP policies.
a. Limited markets: markets for buying and selling profit centers may be
limited, because: existence of internal capacity might limit development
of external sales; if company is sole producer of differentiated products,
no outside source exists; if company has invested significantly in facilities,
it is unlikely to use outside sources unless outside selling price
approaches the company’s variable cost, which is not usual. Even in the
case of limited markets, the transfer price that best satisfies the
requirements of a profit centre system is the competitive price. Competitive
prices measure the contribution of each profit centre to the total company
profits.
How should company find out what the competitive price is, if it does not buy
or sell product in outside market?
- if published market prices are available, can be used to established TP, but
these should be prices actually paid in the marketplace and conditions that
exist outside market should be consistent with those existing within the
company.
- Market prices may be set by bids, can be done only if the low bidder
stands a reasonable chance of obtaining the business
- If selling profit centre sells similar products in outside market, it is often
possible to replicate competitive price on basis of outside price
- If buying profit centre purchases similar products from outside market, it
may be possible to replicate competitive prices for its proprietary products
b. Excess or shortage of industry capacity: selling profit centre cannot sell to
outside market all it can produce (excess capacity). Company may not
optimize profit if the buying profit centre purchased from outside vendors
while capacity is available on the inside. Even if there are constraints on
sourcing, the market price is the best transfer price. If the market price exists
or can be approximated, use it.
5. Cost-based transfer prices — if competitive prices are not available, TP
may be set on the basis of cost + profit. 2 decision must be made in cost-
based TP system: how to define cost and how to calculate profit markup.
a. Cost basis, usual basis is standard costs. Actual cost should not be used
because production inefficiencies will passed on to the buying profit
centre. If this is used, incentive is needed to set tight standards and
improve standards. How the standard cost should be calculated, for
instance, full (absorption) costing or ABC should be applied.
b. Profit markup, to calculate there are 2 conditions: what the profit markup
is based on and level of profit allowed. The simplest and most widely
used base is a percentage of costs. If this base is used, however, no account
is taken of capital required. A conceptually better base is a percentage of
investment, but calculating the investment applicable to a given product
may pose a major practical problem; second problem with the profit
allowance is the amount of profit. Senior management’s perception of the
financial performance of a profit centre will be affected by the profit it
shows. Profit allowance should approximate the rate of return that would
be earned if the business unit was an independent company selling to
outside customers. Conceptual solution: to base the profit allowance on
the investment required to meet the volume needed by the buying profit
centres. The investment would be calculated at a ‘standard’ level with
fixed assets and inventories at current replacement costs.
6. Upstream fixed costs and profits — TP creates significant problem in
integrated companies. Profit centre 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. Even if the final profit
centre was aware of these costs and profit, it might be reluctant to reduce
mitigate this problem:
a. Agreement among business units, negotiated TP. Depending on the
bargaining power and freedom of BU managers. Establish a formal
mechanism whereby representatives from the buying and selling units
meet periodically to decide on outside selling prices and the sharing of
profits for products with significant upstream fixed costs and profit.
b. Two-step pricing, establish TP that include 2 charges: charge is made for
each unit sold that is equal to the standard variable cost of production; a
periodic (usually monthly charge) = fixed cost associated with the facilities
reserved for the buying unit. Charge for contribution margin. One or both
components should include profit margin.
c. Profit sharing, if two step is not feasible, this may be use to ensure
congruence between BU and company interests. VC + share in realized
profit. It operates by: product is transferred to the marketing unit at
standard variable cost; After the product is sold, the business units share
the contribution earned, which is the selling price minus the variable
manufacturing and marketing costs. Some problems of implementing this
method: there can be arguments over the way contribution is divided
between the two profit centres, and senior management might have to
intervene to settle these disputes; arbitrarily dividing up the profits
between units does not give valid information on the profitability of each
unit; as the contribution is not allocated until after the sale has been
made, the manufacturing unit’s contribution depends on the marketing
unit’s ability to sell as well as the actual selling price.
d. Two set of prices (dual pricing), two sets of TP. Manufacturing unit’s
revenue is credited at the outside sales price and the buying unit is
charged the total standard costs. This transfer pricing method is
sometimes used when there are frequent conflicts between the buying
and selling units that cannot be resolved by one of the other methods.
Both the buying and selling units benefit under this method.
7. Shared service centers — subset of ‘non-core’ business functions are
concentrated into a new BU. Shared service centres are seen as an
improved way of structuring and managing support services and the
intention is to capture the best aspects of both centralization and
decentralization.
- advantage of centralization: improve clarity on strategic and long-term
decision taken by top management due to simpler organizational
communication structure, and also economies of scale; advantage from
decentralization: customer focus and quality (service improvement). Concept
of shared service centres has also received heavy criticism. Many shared
service projects fail, or end up costing much more than originally planned.
Since standardization is often a key feature in shared services, there is a risk
that customer demand (with a need for variety) will suffer.
8. Management control and shared service centers — shared service ≠
centralized service units
- head office concerns should not dominate. Shared service centre should be
a relatively free and independent unit within the organization that ideally is
located close to the internal customers.
- Operate as either expense or profit centre with full responsibility for
financial performance and quality of services
- Normally financed by fees charged to the BU
- Service centre takes its strategic direction from top management, but more
importantly forms close relationships with the business units it serves. Top
management is still important in number of dimension: what is considered
core and non-core activities often not easy to decide; top management
need to motivate clearly why shared service centres are implemented as
they are often met with resistance; top management needs to decide if BU
should be permitted to purchase support service outside the company, and
if shared service centre should also be allowed to sell its services to outside
customers.
- Key management control issue for shared service is: determination level of
service business units are willing to pay for and price for the services.
Balance must be found between service quality (accessibility,
responsiveness, timeliness, accuracy) and cost.
Lecture 5: chp 9,10,11
1. Purpose of budgeting
- Planing: Resource distribution; coordination
- Accountability: Monitoring; motivation