We make reference to your letter dated September 1st, 2004 by which you requested our opinion regarding issues related to decentralization, autonomy and transfer pricing policies and their influence on Wickam's current choice of business opportunities.
We intend to present to you the theoretical foundations on which we have based our opinion i.e. transfer pricing policies (definition, functions, issues, methods) and the actual solution we deem as fit for your company. We believe that a slight change of policy should bring more profit as a result of increased convergence, or synergy, between the companies of the Wickam group.
Large organizations are often a conglomerate of two or more smaller firms. These firms have each an entire system of operation parameters on which their daily existence is based. Central management units cannot keep track and control all these parameters for each of the subunits. Therefore, large organizations are in most cases separated into divisions. Each division has its autonomy, which means that its manager is permitted to take all action he or she considers appropriate. However, although the advantages presented by such a model cannot fail to attract attention, there are some week points a CFO should take into consideration. First, it is difficult to evaluate the performance of division managers by the central unit. Second, maximization of the organization's total profit requires coordination of the divisions' actions by central management. Evaluating the performance of each division is done using a method for measuring the contribution of each of the divisions to the total profit of the organization. The usual solution is setting prices for the intermediate goods that are meant to be transferred from one division to another within the organization. The name assigned by researchers to these prices is "transfer prices." Their use includes evaluation of the performance of division managers based on the profit they generate, coordination of the separate decisions of the divisions in order to achieve the common goals of the organizations and to assure convergence, enabling each division to take its own decisions, such as the pricing method of the final product they make and preservation of divisions' autonomy.
There are multiple functions a transfer pricing policy provides: first of all, there is tax evasion. Taxes are the main reason for which shareholders' profits diminish, therefore motivating managers to look for ways to evade taxation. One method involves moving profits to countries with low taxation environments. This is a feature often used by multinational companies and strongly endorsed by international audit companies. One other function of transfer prices is the implementation of rational economic behavior amongst internal clients. If a division wouldn't charge anything or would ask for symbolic prices in return for the delivered goods or the rendered services, wasteful demands of resources would be encouraged. Also, this helps establish a fair value of their services. Another function implies an increase of trading between internal units. Buying from a sister company helps avoid paying for competition's overheads and larger profit margins, and keeps cash flows "in the family," without damaging in any way the financial health of a single unit.
There are a number of issues raised by the use of transfer pricing policies. Swapping and trading goods between internal units of one company is an economically sound policy only if these services are valued at a fair price. If one division obtains a certain product from a sister company with a considerable discount, rational economic behavior is in peril, and ratio analysis is not as effective, since costs aren't actually real. One company might look in perfect financial shape, but it could actually not stand on the market, as its profit margin is corrected by imposed lower costs. However, it is true that the profit margin should not be that great when selling to another division of the same company, but it is absolutely necessary that all costs be covered.
Policies such as transfer pricing have important organizational and behavioral implications. Managers act in a certain way, as they are sure that they can satisfy some of their supply needs with goods at lower costs, and perhaps with some extra advantages, as negotiation is facilitated by central management. The central unit should be careful about the signals it is transmitting to its division managers, so they don't become dependent on internal supply.
The costs produced by transfer pricing policies are both obvious (accounting, administrative) and hidden. The opportunity costs may not be apparent, and losses from bad transfer pricing policies may only become visible after a long period of time.
A classical Transfer Pricing problem usually involves tow divisions in a decentralized organization. By hypothesis, the first division produces an intermediate good and the second transforms it into a final good and then sells it on the market. The second division needs a certain quantity of intermediate goods, which it purchases from the first division at a certain price. This price, or transfer price measures the value of the transaction between the two divisions. This values is viewed as in income for the first division and as an expense for the second, therefore facilitating the determination of the net profit for the two units. Although managers are evaluated on the basis of the profits each of their divisions generate, the final purpose of the mother organization is the maximization of the total profit. Therefore, incompatibility often arises between the objectives of the organization and the goals of the separate units. This problem is solved by figuring out a way in which to determine a pricing rule, and to take into account, at the same time, the objective of the separate divisions. Although, from a mathematically point-of-view, this is an achievable result, the information available to the central management unit is often incomplete and inexact, as unit managers sometimes conceal the information, in order to manipulate the final outcome in their favor. Asymmetry of information has multiple causes, such as the existence confidentiality agreements and the use of different measurement standards (for instance, a unit in a country in which accounting is organized based on the International Accounting Standards may produce different results than the U.S. - which uses FASB's GAAP, although their. activities are similar).
Reality brings even more complications. Asymmetry of information is accompanied by certain constraints. For example, divisions may have capacity or production problems, may face technical difficulties regarding certain products, final products may pass through a chain of two or more divisions, some intermediate goods may be sold for a larger profit on the market etc. There are several methods that are commonly used today and that have been studied by accountancy literature. These include cost-methods, market price and dual price methods and negotiated transfer prices. Please find below a brief description of each one:
Cost methods: The transfer price is a certain function of the production cost of the selling division. It may or may not include a fixed cost component. There are several variations of this approach such as cost plus fixed fee, cost plus a fixed percentage of the cost, full cost plus markup, variable cost, marginal cost.
Market price methods: If there is a market for the intermediate good, then the market price is used as the transfer price. Often the transfer price is the market price minus the selling expenses.
Dual price methods: The price that the selling division receives is not equal to the price that the buying division pays - and is usually higher. This mechanism generates a deficit, which is set off by central management. Because central management sets the optimal transfer price, and hence sets the transaction volume to be optimal, this mechanism yields higher performance than other methods. However, it is not commonly used because it requires central management to be involved in the complex process of price-setting. The Ronen-McKinney mechanism and the Groves-Loeb mechanism are the motivation behind this method.
Negotiated transfer prices: The transfer price is reached by negotiation between the relevant division managers. The advantage of this method is that it preserves the divisions' autonomy. Its problem is the sensitivity of the outcome to the managers' negotiation skills."
There are multiple ways in which a method may be applied. The markup in the cost-plus method may be calculate in relation to the cost, as a percentage of it, therefore producing a return on investment for either the mother company or the division. Performance is greatly influenced by the transfer pricing policy an organization uses, and this problem still leaves enough room for discussions and interpretations.
Please find below an analysis of the situation at Wickam, whereon we have based our opinion.
In the first case, Tumut produces the boxes. The Craft division has a single negative cash-flow, which includes the price of the boxes, as agreed with Ms. McNeil. Tumut has in all of the three cases a negative cash-flow of $160, due to the fact that Tumut has spent a period of time working on the box…