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Introduction Medoc Company is faced with some problems in its transfer pricing policy between 2 of its 15 investment centres within the firm, namely the Milling Division and the Consumer Products Division. The transfer price set by the firm actually created some friction between these 2 divisions.
Dealing with warehousing, shipping, billing, advertising and other sales promotion efforts for the consumer products and a fraction of the flour produced by the Milling Division, the Consumer Products Division complained that it was charged an inappropriate cost for all the items transferred from the Milling Division and thus it had little motivation to pursue more aggressive marketing efforts given that it had to do it at the expense of reducing its own average profit margin. And there are still several other complaints from the Consumer Products Division in relation to this as well.
The transfer price charged to the Consumer Products Division was based on the full cost approach where every unit was charged at actual cost including material, labour, variable overhead and non-variable overhead with an additional charge of 75 percent of the investment in Milling Division. This caused three main identifiable problems: Managers’ goals are not aligned with the company’s goal as the cost behaviour is altered after transferring to the Consumer Products Division. Consumer Products Division’s is charged 75 percent of investment of Milling Division despite the fact that they had no control over Milling Division.
The inefficiencies of the Milling Division could be passed on to the Consumer Products Division through the transfer prices charging at actual cost. To solve these problems, the firm had examined different transfer pricing approaches but it was hard to decide on which method to use due to the different compositions of the products and the market price of is not readily available and could not be measured accurately. Also, the top management wants profit of the two divisions measured separately, hence combining the two divisions for profit reporting purposes had been ruled out.
Given the situation, a tentative suggestion has been made. The proposed method was that the transfer price should consist of 2 elements. One is the variable cost which will comprise the actual material, labour and variable overhead costs applied to each unit and the other is a standard monthly charge representing the Consumer Products Division’s “fair” share of the non-variable overhead on the fraction of the products transferred and a return of 10 percent on the same fraction of the Milling Divisions investment.
Ideal Situation In order to see what changes could be made to improve the transfer price mechanism, the ideal situation is considered. Working towards the ideal will definitely help reduce the problems faced. Ideally, managers should be far sighted, taking care of the long run as well as short run performances of their responsibility centres. The staff involved in negotiation and arbitration must also be competent. Secondly, there must be good atmosphere where managers perceive the transfer prices are fair.
Next, the ideal transfer price is based on a well-established, normal market price for identical product being transferred. Alternatives for sourcing should also exist where buying manager can buy from a third party and selling manager is also free to sell to a third party. Managers should have access to full information about the available alternatives and the relevant costs and revenues of each. Lastly, there must be a smooth working mechanism for negotiating “contracts” between business units. These ideal conditions will induce goal congruent decisions in the transfer price system.
Thus, they shall be referred to as a guide in our recommendations. Recommendation with Organizational Structure Constraints Thus, our solution is aimed to solve the problems noted above. We propose to use a pure two step full cost transfer. We will use a monthly fixed cost component and a variable cost component (depending on the amount of products transferred). The monthly fixed cost will consist of two sub-components: the allocated percentage of budgeted non-variable overhead and an allocated percentage to total investment cost of the Milling Division.
For variable cost, instead of charging fully at the actual cost as proposed in the case, we should charge it with two sub-components: a standard cost for the cost the Miller Division can control (labour, variable overhead, other ingredients and packaging material) and an actual cost for the flour. The reason behind the actual cost for the flour is because the Milling Division should not be held responsible for the fluctuation of prices of wheat, neither can this be blamed on the Grain Department since this is more ttributable to the market demand and supply (like oil prices, hence, we can think about hedging). It is anticipated that the Consumer Products Division will complain about the high charge of investment cost and they did not participate in making the decisions regarding acquisition of new equipments, but the rationale of the Milling Division buying new machines must be because it will be more cost effective or time saving. After all, Milling Division will not purposefully sabotage their own cost structure by having new machines that are inferior to the current machines.
It is also anticipated that the Milling Division will complain that they will have to bear the cost of unanticipated errors (accidents) but by charging standard cost on controllable items, but this helps them to improve and avoid all errors to keep cost low. So in conclusion, the solution we presented is better than the proposed solution by the top management, because there is consideration of factors like goal congruence, inefficiencies of the Milling Division, the uncontrollability of wheat prices to reach a reasonable and fair transfer price method.
Recommendation without Organizational Structure Constraints If there were no organizational structure constraints, a possible solution is to consider modifying its current structure to Strategic Business Units (SBUs) where a SBU is an operating unit or planning focus on a group of distinct set of products sold to a uniform set of customers and facing a well-defined set of competitors. It will help to address each market which company operates in. The organization of the business unit is determined by the needs of the market.
In the case of Medoc, two SBUs namely Flour Division and Consumer Products Division can be formed from the current Milling Division and Consumer Products Division. The idea of changing the current divisions to the new business units is to allow each unit to focus on a single major product line, to have their own competitors and a manager to be held accountable for operations which can independently plan for. The Flour Division will replace the Milling Division where they will continue to mill flour.
However, the Flour Division shall also be responsible for the sales of flour to all industrial users which include those originally serviced by Consumer Products Division. At the same time, the Flour Division will be responsible for the warehousing, shipping, billing, collections, advertising and other sales promotion efforts for flour sold to the different sets industrial users. Consumer Products Division will be concentrating on consumer products and instead of obtaining products from the Milling Division.
Hence the Flour Division will only transfer flour to the Consumer Products Division. The current consumer products that are sold by the division to consumers will therefore be produced by the Consumer Products Division. This helps to reduce the problem of difficulty in obtaining a market price for transfer pricing due to different product compositions. The transfer price that the two divisions will be concerned with will be just the transfer price of flour where the market price can be relatively easier to obtain.
The Consumer Products Division will also have the freedom to source for flour from third parties if the transfer price is not agreeable. In order to make these changes possible, there has to be manpower shuffling between Milling and Consumer Products Divisions. The employees with the expertise on consumer products production from Milling Division will be shifted to the Consumer Products Division and those with expertise on servicing industrial customers in the Consumer Products Division will be moved to the Flour Division.
By modifying the current structure to the SBUs, the transfer pricing mechanism will be enhanced as it move towards the ideal situation mentioned above. As each SBUs acts more like individual businesses, managers will be concerned about both the long-run and short-run performances of their own business unit. This, in turns, benefits Medoc as a whole. The Managers, now acting like entrepreneurs, will develop the creativity and competence needed in running the SBUs.
As the SBUs are now wholly responsible by the managers, the profitability in the income statements will be reflective of the managers’ performances. Thus, managers should perceive the transfer price as fair. This will only be so if the transfer price is set under good atmosphere. Fortunately, with the new proposed changes, setting a reasonable transfer price will be relatively easier. As each SBUs are now in charge of a distinct set of products sold to a uniform set of customers and face a well-defined set of competitors, market price of identical or similar products can be identified.
Managers will then have sufficient information, if not full, to decide whether it is best to purchase or sell their products to the outside market, or to transfer them to the other SBUs. This is unlike the current situation where the Milling Division has to transfer multiple products with different product compositions. To set the transfer price, the market price can then be adjusted downwards to reflect the saving in cost such as advertising, if the product is being transferred internally.
Although the benefits of changing into SBUs as mentioned above are significant, the fact that whether an organizational redesign can be implemented successfully remains questionable. Management of Medoc Company needs to pay great attention in the transitional period from one organizational design to another since a successful implementation requires a good transitional management. Getting all the problems answered may not be possible but still, it is undeniably a pre-requisite that management must have a good understanding of new goals, objectives, roles, expectations and the employees’ concerns.
Different challenges must be accounted for. For example, when letting each division to be held responsible for the operations of a major product line, the problem of lacking in skills and expertise could arise. Transferring staff from the Consumer Products Division to Flour Division may solve the problem. Still, such changes come with status changes and new informal organizations probably will create fear in the employees and hence employees may be resistance to staff reassignment.
In addition to these personnel problems, shifting the manufacturing of consumer products to another division certainly calls for a new resource allocation. Questions like how resources should be distributed between the two divisions; how to apportion the flour produced so that an appropriate fraction is transferred to the Consumer Products Division and etc, have to be considered by the management beforehand. Costs of the organizational redesign may also pose a problem since the transition may require more capital than expected.
Furthermore, the trust built between the company and the industrial buyers of the Consumer Products Division might have to be rebuilt after the changes as those buyers will now deal with the Flour Division. Therefore, even though the recommendation of organizational structure changes seems feasible and appear to be a solution to the existing transfer pricing problem, in practice the results from the changes will depend greatly on the organizational behaviour of the company as well as the management commitment and their decision on how to overcome obstacles during the transitional period.
Conclusion The solution that is proposed based on the organisational structure is a pure two step full cost transfer with an allocated fixed cost (comprise of non-variable overhead and investment cost) with a variable cost (depending on units transferred) set using actual cost on flour and standard cost for all the other variable items. By using this, this will induce more accurate demand forecast and prevent buying division from running away from their fair share of investment cost.
Standard costing on controllable items for the selling division will prevent inefficiencies from passing to the buying division in term of cost. All in all, this will promote goal congruence in the different divisions within the company. If the organisational structure is flexible to changes, it is possible to solve the current problems faced by changing the structure to Strategic Business Units where the selling division will produce and transfer only flour to the buying division.
All the industrial users currently served by the Consumer Products Division will be served by the Milling Division. Consumer Products Division will produce the flour-made consumer products (currently produced by Milling Division). This allows the reduction of complexity of transfer products and a well definition of the sets of customers and competitors. Also, better information about the market prices of transfers can be obtained. These changes will allow the company to move towards the ideal situation of transfer pricing.
However, despite the benefits of the changes far outweighs the cost, it has to be noted that such organisational structure changes are normally greeted with resistance from the different departments involved and difficulties may arise like resource reallocation and great changes in customer relationship management. The outcome of such reorganisation will be heavily dependent on the effort of top management during the transitional period.