A P P LYING D IFF E RENTIAL A NALYS IS TO T R ANS F E R P RICING

A P P LYING D IFF E RENTIAL A NALYS IS TO T R ANS F E R P RICING

Assume E-Z Computing, which manufactures and sells various computer products, has two decentralized divisions, Production and Marketing. Marketing has always purchased a particular mouse from Production at $50 per unit. Production is considering raising the price to $60 per unit.

Assume the Production Division’s costs related to mouse production are as follows: Variable costs per unit: $50

Monthly fixed costs: $10,000 Marketing handles the promotion and distribution of the mouse it purchases from Production and

sells each mouse for $100. Marketing incurs monthly fixed costs of $5,000. Marketing sells 1,500 units per month.

Each of the following situations is a type of make-or-buy decision, where either Production makes the mouse for Marketing or Marketing buys the mouse from outside suppliers.

Case 1: Transfer Pricing When Production Division Is Below Capacity. (Assume a transfer

of $50 per unit.) Case 2: Transfer Pricing When Production Division Is At Capacity. (Assume a transfer of

$60 per unit.)

Case 1: Transfer Pricing When Production Division Is Below Capacity First consider each division’s profits and the company’s profits if Marketing purchases the mouse

from Production for $50 per unit. As Panel A of Exhibit 11.2 shows, the Production Division has a loss of $10,000, the Marketing Division makes a profit of $70,000, and the company makes a profit of $60,000.

Now assume that Marketing buys units from an outside supplier for $60 per unit. The facilities Production uses to manufacture these units would remain idle. As shown in Exhibit 11.2, Panel B, the result of purchasing units from an outside supplier reduces companywide operating profits by $15,000 compared to the Panel A results. The differential cost for the company to make the units is $50 per unit, whereas the differential cost to buy is $60 per unit. The cost savings for making over buying is $15,000 [

Case 2: Transfer Pricing When Production Division Is At Capacity Using the same data as above for E-Z Computing, we make one change in our assumptions;

namely, assume Production does not have idle capacity. It can sell all the units it can produce to outside customers at $60 per unit. If Production sells to Marketing, it will have to forgo sales to outside customers. Which option yields the highest total company operating profit for E-Z Computing: Marketing buys from Production or buys from outside supplier?

As shown in Exhibit 11.3, the company’s profits are the same whether Marketing buys from Production or from outside. All parties are indifferent to purchasing inside or outside the

398 Chapter 11 Investment Center Performance Evaluation

organization. Production’s profits are $5,000 either way, Marketing’s profits are $55,000 either way, and E-Z’s profits are $60,000 either way. If Production can sell to outsiders for a price greater than $60 per unit, then E-Z Computing will benefit from Production’s selling to outsiders and having Marketing buy from other outsiders.

Altern ative Ways to S et Transfer Price s

Management’s problem is to set transfer prices so that the buyer and seller have goal congruence with respect to the organization’s goals. Although there is no easy solution to the transfer pricing problem, there are three general alternative ways to set transfer prices:

1. Top management intervenes to set the transfer price for each transaction between divisions.

2. Top management establishes transfer price policies that divisions follow.

3. Division managers negotiate transfer prices among themselves. Each of these approaches has advantages and disadvantages. We discuss these alternatives in the

next sections.