Mylar Corporation started as a single plant to produce its major components and then assembled its main product into electric motors. Mylar later expanded by developing outside markets for some components used in its motors. Eventually, the company reorganized into four manufacturing divisions: bearing, casing, switch, and motor. Each manufacturing division operates as an autonomous unit, and divisional performance is the basis for year-end bonuses.
Mylar's transfer pricing policy permits the manufacturing divisions to sell either externally or internally. The price for goods transferred between divisions is negotiated between the buying and selling divisions without any interference from top management.
Mylar's profits for the current year have dropped, although sales have increased, and the decreased profits can be traced almost entirely to the motor division. Jere Feldon, Mylar's chief financial officer (CFO), has learned that the motor division purchased switches for its motors from an outside supplier during the current year rather than buying them from the switch division, which is at capacity and has refused to sell to the motor division. It can sell them to outside customers at a price higher than the actual full (absorption) manufacturing cost that has always been negotiated in the past with the motor division. When the motor division refused to meet the price that the switch division was receiving from its outside buyer, the motor division had to purchase the switches from an outside supplier at an even higher price.
Jere is reviewing Mylar's transfer pricing policy because he believes that sub-optimization has occurred. Although the switch division made the correct decision to maximize its division profit by not transferring the switches at actual full manufacturing cost, this was not necessarily in Mylar's best interest because of the price the motor division paid for them. The motor division has always been Mylar's largest division and has tended to dominate the smaller divisions. Jere has learned that the casing and bearing divisions are also resisting the motor division's expectation to use the actual full manufacturing cost as the negotiated price.
Jere has requested that the corporate accounting department study alternative transfer pricing methods to promote overall goal congruence, motivate divisional management performance, and optimize overall company performance. Three transfer pricing methods being considered follow. The one selected will be applied uniformly across all divisions.
• Standard full manufacturing cost plus an appropriate markup.
• Market selling price of the products being transferred.
• Outlay (out-of-pocket) costs incurred to the point of transfer plus opportunity cost to the seller, per unit.
Required
1. Discuss the following:
a. The positive and negative motivational implications of employing a negotiated transfer pricing system for goods exchanged between divisions.
b. The motivational problems that can result from using actual full (absorption) manufacturing costs as a transfer price.
2. Discuss the motivational issues that could arise if Mylar Corporation decides to change from its current policy of negotiating transfer prices between divisions to a revised policy that would apply uniformly to all divisions.
3. Discuss the likely behavior of both buying and selling divisional managers for each transfer-pricing method listed earlier (i.e., standard full manufacturing cost plus an appropriate markup, market selling price of the products being transferred, and the sum of outlay [out-of-pocket] costs plus opportunity cost to the seller, per unit), if it were adopted by Mylar?