CASE STUDY ON MEDOC COMPANY

Ashwani Gautam Ish Kumar Ram Kinker Sudha Jangra

Objectives of transfer pricing

It should provide each business unit with relevant information it needs to determine the optimum tradeoff between company costs and revenues. y It should help to measures the economic performance of the individual business units. y The system should be simple to understand and easy to administer.
y

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

The Ideal Situation

Competent people y Good atmosphere y A market price y Freedom to source y Full information y Negotiation
y

Constraints on sourcing
The existence of internal capacity might limit the development of external sales. y If the company is the sole producer of a differentiated product, no outside source exists.
y

Methods of Calculating Transfer Prices

Methods of Calculating Transfer Prices

Based on Competitive Price :
Published market price. Market price by BID If selling profit centre sells product in out side market, it can replicate the price. If buying profit centre purchase similar product from out side market, it can replicate the price. Excess Capacity  Shortage Capacity  Arbitration committee( or a central person)  Internal Rivalry


Cost based Transfer pricing: Transfer prices may be set on the basis of cost plus a profit Two decisions that has to be made are: yHow to define cost? yHow to calculate profit mark up?

Cost basis y Normally it is calculated with standard cost. y Actual costs should not be used because production inefficiencies will be passed on to the buying profit center. y Eg

Profit mark up Two decisions that has to be made are: What the profit mark up is based on? What the level of profit allowed? Normally it will be based on percentage of cost, even though profit mark up based on investment is a better.

Methods To Overcome Problems In Transfer Pricing

Agreement among business units Two step pricing Profit sharing Two sets of prices

Agreement among business units

x It is a formal mechanism where representative of buying and selling unit meet periodically and decide on outside selling prices and sharing of profits x Limited to decisions that involve significant amount of business to at least one of the profit centers.

Two step pricing

This establishes a transfer price that includes charges. For each unit sold, a charge is made that is equal to: y Standard variable cost of production y fixed costs - periodically set (usually monthly) y One or both of these should include profit margin y Eg
y

Advantages The monthly charge for fixed costs and profit is negotiated periodically and depend on capacity reserved for buying unit Under this pricing system, manufacturing unit`s performance is not affected by sales volume of the final unit Disadvantages There may be conflict of interests between manufacturing/selling unit and those of the company Eg

Profit sharing
y

This system is used to ensure congruence between business unit and company interest
The product is transferred to the marketing unit at standard variable cost The business units share the contribution earned after the product is sold

Disadvantages There may be arguments over the way contribution is divided between two profit centers These division will not give profitability at each center Contribution is allocated only after the sales, so manufacturing unit`s contribution depends on marketing unit`s ability to sell and on market price

Two sets of prices

In this method the selling centre`s revenue will be credited at outside sales price and the buying unit is charged the total standard costs. The difference will be charged to head quarters account. Conflicts over transfer prices create problems in either organizational structure or other management systems. Such conflicts can be overcome by two sets of prices

Disadvantages Sum of the business unit profits is greater than overall company profits This system creates an illusive feeling that business units are making money Actually overall company might be losing money because of debits to HQ This system motivates business units to concentrate more on internal transfers There is need for additional book keeping involved in first debiting the HQ`s account.

Administration of Transfer Price

Administration of Transfer Price

How the selected policy sould be implemented y The degree of negotiation allowed in selling transfer prices y Methods of resolving transfer pricing conflicts y and, classification of the products according to appropriate method.
y

Negotiation
y y

In a company business units must negotiate transfer prices Transfer prices are not set by central staff group. Because of the belief that establishing selling price and arriving at satisfactory purchase price is the primary function of the line manager. If the headquartes control pricing the line managements ablility will affect profitability.

Negotiated transfer prices are always the result many compromises made by the buyer and seller. y The business units have the best information on markets and costs. y They are best able to arrive at reasonable prices. y The business units have ground rules within which transfer price has to be negotiated.
y

Line managers should not spend undue amount of time on transfer pricing negotiations, y so these rules should be specific enough to prevent negotiating skills from being a significant factor in determining transfer pricing.
y

Arbitration and Conflict Resolution

The procedure for arbitrating transfer pricing disputes: The responsibility of arbitating disputes is assigned by a single executive. He dicusses with business unit managers and orally announces the price.

1. 2. 3. y y

Setting up a committee The committee will have 3 main responsibilities: Settling transfer price disputes Reviewing sourcing changes Changing transfer price rules when appropriate. In any case transfer price arbitration is the responsibility of the top management It can also be done by conflict resolution method such as forcing and bargaining.

Product Classification
The extent and formality of sourcing and transfer pricing rules depend to a large extent on the number of intercompany transfers and availability of market prices. y The greater the number of intracompany transfers and the availability of market prices, the more formal and specific the rules are.
y

Some companies divide products into 2 classes: 1.The senior management wishes to control the sourcing. 2.The products are produced outside the company.

Class 1 y The senior management wishes to have control over sourcing. y Includes large volume products. y No outside source exist y Products over whose manufacturing, quality has secrecy reasons. y The products can be changed only by the top management.

Class 2 y The products are produced outside the company y Relatively smaller volume y Products are determined by the business units involved. y Both the buyer and seller are free to deal either inside or outside the company.

The decisions involved in designing the transfer pricing system: 1.Sourcing decision 2.Transfer pricing decision.

MEDOC COMPANY

Case facts of MEDOC company

The milling division of the Medoc company milled flour and manufactured a variety of consumer products from it

Facts
1. Approximately 70% was transferred to the consumer products division and marketed by this division through retail stores. It handles ware housing, Advertising.

CONTD..
2.Approximately 20% was sold by the milling division as flour to large industrial users. 3.Apporximately 10% was flour transferred to the CPD and sold by that division to industrial users, but in different industries than those serviced directly by the milling division.

ACTUAL DIVISION OF FIOUR

PERCENTAGE

CPD MD IS

CONTD..
y y y

Wheat was purchased by the grain department, which was separate from milling division. The price of wheat fluctuated frequently. Other ingredients and supplies were purchased by MD

Cost included elements in following proportion. proportion.

Elements Cost in percentage

y y y y y

Flour Other ingredients and packaging material Labor and variable OHs Non variable OHs Total

30 y 25
y y

20

25 y 100
y

Contd Contd
75% of milling divisions investment was charged to in the CPD computing the latters return on investment. Friction between MILLING DEPARTMENT and CONSUMER PRODUCT DIVISION primarily for three reasons.

Friction between milling department and CPD

Milling division alleged that the CPD was not aggressive enough in seeking this capacity-filling volume. 2. CPD did not participate in any of the decisions regarding the acquisition of new equipment. {how ever the people in MD were technically more competent to make decisions} 3. The CPD complained that since products were charged to it at actual cost, it must automatically pay for production inefficiencies that were the responsibility of the MD.
1.

CONTD
A care full study had been made of the possibility of relating the transfer price either to a market price or price charged by MD. y The CPD currently earned about20% profit ROI,MD earned about 6% top managements decisions
y

proposal
1.

2. 3.

A standard monthly charge representing the CPD fair share of non variable OHs,plus Per unit charge equivalent to the VCs Investment would no longer be allocated to CPD

Non variable OHs charge

A fraction of the budgeted non variable oh cost of MD, corresponding to the fraction of products that was estimated would be transferred to the CPD. y A return of 10% on the same fraction of MD investment. This was higher than the return that the MD earned on sales to industrial users
y

Questions

What would you recommend given the organizational structure constraints in the case?

y y

Since Milling Division is supplying at actual cost, CPD could purchase the surplus capacity of 2% . The Consumer Product Division could increase the volume of consumer sales by increasing its marketing efforts and by offering more attractive special deals. It could also do more to obtain industrial business at a price which, although not profitable, would still result in a smaller loss than what the Milling division currently incurred. This additional volume would benefit the company even though it reduced the average profit margin of the Consumer Product Division.

What would you recommend if there were no organizational structure constraints on your options?

If there were no organizational structure constraints, the transfer price could be revised either to market price or the price charged by the Milling Division to its industrial customers