mcs transfer pricing with gac case

General Appliance Corporation

Group members Roll nos.

Swapna Rao 09Salman Khatri 22Vani Mangalur 28

Frenzina Rodrigues

38Sohini Surani 52Aniruddha Tulaskar

57

Monday, March 7, 2011

Transfer Pricing

Definition: The term “transfer price” is the

internal price charged by a selling department, division, or subsidiary of a company for a raw material, component, or finished good or service which is supplied to a buying department, division , or subsidiary of the same company.


Production

Manufacturing

Marketing


Objectives of Transfer Pricing

To provide each business unit relevant information to determine trade-off between company costs & revenues.

To induce goal congruent decisions that will improve business unit profits & company profits

To measure economic performance of individual business unit.

The system must be simple to understand & easy to administer.


• The fundamental principle is that the transfer price should be similar to the price that would be charged if the product was sold to outside customers or purchased from outside vendors.

• Sourcing decision: To produce in-house or outsource

• Transfer Price decision: If produced in-

2 vital questions to be asked


Market based price

• Definition:• The ideal transfer price is based on a

well- established, normal market price for the identical product being transferred—

i.e., a market price reflecting the same conditions (Quantity, Delivery Time & Quality) as the product to which the transfer price applies.


Cost based price

• Definition:• If competitive prices are unavailable

transfer prices may be set on basis of cost + profit although such prices are complex to calculate & results are less satisfactory than market based cost.

• The usual basis is standard cost (budgeted cost), in order to avoid production inefficiencies from being passed to the buying profit center.

How to arrive at cost?


How to arrive at Profit markup?

Percentage of cost

No account taken of capital required

Percentage of investment

Account taken of capital required


Cost based transfer pricing involves

Two Profit


Two step pricing

First step • For each unit sold, a charge is made = Standard (budgeted) Variable cost of production

Second step• Periodic (monthly)charge is made = Fixed Cost associated with facilities reserved for buying unitOne or both of these steps should

include a Profit Margin


• Firstly, the product is transferred to marketing unit at standard variable cost

• After the product is sold the biz unit share the contribution earned . i.e. ,

Selling Price (-) Variable Manufacturing &

Marketing costs

____________________________________ = Contribution


3 ways of Pricing Corporate Services

Biz unit should pay Standard Variable cost of

services

Biz unit should pay Std Variable Cost + Std Fixed Cost

i.e. Full Cost of services

Biz unit should pay Standard Full cost + Profit Margin

for services


Negotiation• Biz units negotiate transfer prices with each other.• Top Mgmt. doesn’t get involved in transfer pricing decisions

Arbitration• 2 parties involved in a dispute submit a written case to a Third person known as Arbitrator for resolution• Mainly performed by Single Executive or a

Conflict Resolution• 4 ways to resolve conflicts namely Forcing, Smoothing, Bargaining & Problem Solving.


Board of Directors

President

Finance EngineeringManufacturing IndustrialRelations staff

Purchasingstaff

Marketing staff

Group vice presidentManufacturing divisions

Group vice presidentProduct divisions

Chrome Product

GearAnd

Stamping division

ElectricMotor

ElectricStove

division

Laundry Equipment

division

MiscellaneousApplianceRefrigeration

division

Organizational Chart Of

GAC


• The product division designed, engineered, assembled , and sold various home appliances.

• They assembled the appliances from parts purchased either from the manufacturing divisions or from outside vendors.

• The manufacturing divisions made approximately 75 percent of their sales to the product divisions.


• Transfer prices were arrived at by negotiation between the divisions.

• These prices generally were based on the actual prices paid to outside suppliers for the same or comparable parts.

• If the divisions could not agree on a price, they could submit the dispute to the finance staff for arbitration.


Problems in the case


Board of Directors

President


Purchasingstaff

Marketing staff



Chrome Product

GearAnd

Stamping division

ElectricMotor

ElectricStove

division

Laundry Equipment

division


division

Issue no. 1


• Chrome Products Div (CPD) sold to Electric Stove Div(ESD) – chrome plated unit fitted on top of stove: it had to be resistant to corrosion, stain from spilled food.

• Initially outsourced, since 1 Jan 1986, manf by CPD.

• Rise in customer complaints in quality--mid 1986

• Manf VP was asked to improve quality of product.

• Solution: Copper plating and buffing


Present price $10Cost of added operation 0.80 centsProfit mark up 0.10 centsNew price $ 10.90

Chrome Products Div Electric Stove Div Finance Staff Review• Added processes to manf. cycle at cost of 80 cents

•Process resulted in improved quality

•The cost of 90 cents was justified since if procured from outside vendor, it would cost the same.

• ESD was not responsible for so called improvement in quality that it neither requested nor approved

•Marketable Features could have been added instead of quality improvement.

•New Product quality level raised to outside vendor’s product quality, hence it

•Engr dept stated proposed cost of 90 cents was reasonable.

•Quality control dept stated new parts were of superior quality as compared to outside vendor.

Situation


Board of Directors

President


Purchasingstaff

Marketing staff



Chrome Product

GearAnd

Stamping division

ElectricMotor

ElectricStove

division

Laundry Equipment

division


division

Issue no. 2


Issue 2: Thermostatic Control • Electric motor Div (EMD) produced

Thermostatic Control units.• Refrigeration Div procured this unit from

outside vendor till 1985.• At request of EMD, Ref Div purchased 25%

from EMD in 1985 & subsequently increased its procurement to 100 % in 1987.

• Supply increased & Demand reduced leading to decline in price level.

• Outside vendor offered to supply the product at a reduced price of $ 2.15. However, EMD refused to reduce its price


SituationElectric Motor Div Refrigeration Div Finance Staff Review

•EMD stated the outside vendor’s price of $ 2.15 was a distress price to save his business, & not valid basis for determining an internal price.

•At $2.15, EMD would never realize profits.

•If forced to accept this price, EMD would shut down its plant & ask outside suppliers

• RD stated they did actually purchase the product for $ 2.15 from outside vendor

•Moreover outside vendor had capacity to produce its full requirement at $ 2.15/unit.

•RD should be allowed to request quotations from outside in the event of major pricing

•Purchasing staff asked to review the outside market situation. They concluded that prices reduced as a result of excess capacity.

•It was concluded that RD could purchase its requirements for next 2 yrs at $2.15/unit.


Board of Directors

President


Purchasingstaff

Marketing staff



Chrome Product

GearAnd

Stamping division

ElectricMotor

ElectricStove

division

Laundry Equipment

division


division

Issue no. 3


Issue 3: Transmission Problem• Laundry Equipment Div(LED) produced

automatic washers. It purchased its transmission from 2 sources: Gear & Transmission Div(GTD) & Thorndike Machining Corp(TMC)-outside vendor.

• Agreement between GAC & TMC, its renewal.• President of TMC proposed a reduction in

price if the agreement was extended from $12 to $10.

• GTD agreed to produce the product in-house at same price & so no question of


SituationLaundry Equipment Div

Gear & Transmission Div

Finance Staff Review• LED stated they could procure from out at $ 11.25. •GTD agreed to produce all transmissions at this price & avoid business with TMC.•Intra-company pricing policy stated buying & selling at competitive prices.

• the $10 quote by TMC was invalid as it was a desperate effort for business sustenance.•It was not a valid basis for determining an internal price.•Project was approved at $12/unit.•LED didn’t comment on proposal on time, hence they could not object later on.

• it was concluded that quote of LED of $ 11.25 was appropriate.•Quote of $12 by GTD was faulty, as they didn’t allow for design elimination, which would reduce costs/unit by 50 cents.•The purchase staff stated that transmissions should be obtained at quoted price level of $ 11.25.


SWOT


Strength

Unit/Division could procure or sell the product at competitive prices because of existence of Intra-company pricing policy.A separate committee called

Finance Staff Review for smooth & quick settlement of intra-

divisional disputes.


Weakness

Product Divisions did not have the autonomy to take sourcing

- make/buy decisions.

Miscommunication between divisions leading to transfer

pricing disputes.


Opportunity

GAC’s Manufacturing division had the opportunity to tap

outside markets.

Scope for GAC to increase production capacity to nullify

the threat from outside vendors.


Threat

Outside vendors supplied similar products at competitive

prices.

Outside vendors had large production capacity installed

thereby giving benefits of economies of scale to GAC.


Recommendati

Need to have a formal channel of

communication for smooth biz

transactions.

In depth scrutiny of projects by top

mgmt & concerned divisions before project approval.

Authority to take sourcing decisions.

Need to devise an accurate

measuring tool for checking

Increase in-house

production capacity as per


mcs transfer pricing with gac case

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