MEDOC Provisional

Ashwani GautamAshwani GautamIsh KumarIsh KumarRam KinkerRam KinkerSudha JangraSudha Jangra

CASE STUDY ON MEDOC COMPANY

Objectives of transfer Objectives of transfer pricingpricingIt should provide each business unit

with relevant information it needs to determine the optimum tradeoff between company costs and revenues.

It should help to measures the economic performance of the individual business units.

The system should be simple to understand and easy to administer.

Fundamental principleFundamental 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 SituationThe Ideal SituationCompetent peopleGood atmosphereA market priceFreedom to sourceFull informationNegotiation

Constraints on sourcingConstraints on sourcingThe existence of internal capacity

might limit the development of external sales.

If the company is the sole producer of a differentiated product, no outside source exists.

Methods of Methods of Calculating Transfer Calculating Transfer

Prices Prices

Methods of Calculating Methods of Calculating Transfer PricesTransfer 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:How to define cost?How to calculate profit mark up?

Cost basisNormally it is calculated with

standard cost.Actual costs should not be

used because production inefficiencies will be passed on to the buying profit center.

Eg

Profit mark upTwo 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 Methods To Overcome Problems In Transfer PricingIn Transfer Pricing

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

Agreement among business Agreement among business unitsunits

It is a formal mechanism where representative of buying and selling unit meet periodically and decide on outside selling prices and sharing of profits

Limited to decisions that involve significant amount of business to at least one of the profit centers.

Two step pricingTwo step pricingThis establishes a transfer price that

includes charges. For each unit sold, a charge is made that is equal to:

Standard variable cost of productionfixed costs - periodically set (usually

monthly)One or both of these should include

profit marginEg

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 unitDisadvantages•There may be conflict of interests between manufacturing/selling unit and those of the company•Eg

Profit sharingProfit sharingThis 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 pricesTwo 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 PriceAdministration of Transfer Price

Administration of Transfer PriceAdministration of Transfer Price

How the selected policy sould be implemented

The degree of negotiation allowed in selling transfer prices

Methods of resolving transfer pricing conflicts

and, classification of the products according to appropriate method.

Negotiation 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.

The business units have the best information on markets and costs.

They are best able to arrive at reasonable prices.

The business units have ground rules within which transfer price has to be negotiated.

Line managers should not spend undue amount of time on transfer pricing negotiations,

so these rules should be specific enough to prevent negotiating skills from being a significant factor in determining transfer pricing.

Arbitration and Conflict ResolutionArbitration 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.

Setting up a committee The committee will have 3 main

responsibilities:1. Settling transfer price disputes2. Reviewing sourcing changes3. 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 ClassificationProduct 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.

The greater the number of intracompany transfers and the availability of market prices, the more formal and specific the rules are.

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

Class 2The products are produced outside the companyRelatively smaller volumeProducts are determined by the business units involved.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 decision2.Transfer pricing decision.

MEDOC COMPANYMEDOC COMPANY

Case facts of MEDOC Case facts of MEDOC companycompany

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

Facts 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..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 FIOURACTUAL DIVISION OF FIOUR

CONTD..CONTD..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 Cost included elements in following proportionproportion..

Elements Cost in percentage

FlourOther ingredients and

packaging materialLabor and variable OH’sNon variable OH’s Total

3025

20

25100

ContdContd…………

75% of milling division’s investment was charged to in the CPD computing the latter’s return on investment.

Friction between MILLING DEPARTMENT and CONSUMER PRODUCT DIVISION primarily for three reasons.

Friction between milling department Friction between milling department and CPDand CPD

1. 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.

CONTD…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.

The CPD currently earned about20% profit ROI,MD earned about 6%

top managements decisions

proposalproposal

1. A standard monthly charge representing the CPD fair share of non variable OH’s,plus

2. Per unit charge equivalent to the VC’s

3. Investment would no longer be allocated to CPD

Non variable OH’s chargeNon variable OH’s chargeA 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.

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

QuestionsQuestions

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

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