1. How does the transfer pricing system overcome the limitations of marginal cost transfer pricing?
2. Why is it important that capacity costs are taken into account when making pricing and product mix decisions?

Teva Pharmaceutical Industries Ltd reorganized its pharmaceutical operations into decentralized cost and profit centres. Teva proposed a transfer pricing system based on marginal costs. But the proposed transfer pricing system generated a storm of controversy. First, some executives observed that the marketing divisions would report extremely high profits because they were being charged for the variable costs only. Second, the operations division would get ‘credit’ only for the variable expenses.
There would be little pressure and motivation to control non-variable expenses. Third, if Teva’s plants were less efficient than outside manufacturers of the pharmaceutical products, the marginal cost transfer price would give the marketing divisions no incentive to shift their source of supply. An alternative approach had to be found.

Teva’s managers considered, but rejected, several traditional methods for establishing a new transfer pricing system. Market price was not feasible because no market existed for Teva’s manufactured and packaged pharmaceutical products that had not already been marketed to customers. Senior executives also believed strongly that negotiated transfer prices would lead to endless arguments among managers in the different divisions, which would consume excessive time on non- productive discussions.
Teva solved its transfer pricing problem by using ABC. Transfer prices are calculated in two different procedures. The first one assigns unit- and batch-level costs and the second assigns product-specific and plant-level costs. The marketing divisions are charged for unit-level costs (principally materials and labour) based on the actual quantities of each individual product they acquire. In addition, they are charged batch-level costs based on the actual number of production and packaging batches of each product they order. The product-specific and plant-level expenses are charged to marketing divisions annually in lump sums based on budgeted information. What about unused capacity? To foster a sense of responsibility among marketing managers for the cost of supplying capacity resources, Teva charges the marketing division that experienced the decline in demand a lump-sum assignment for the cost of maintaining the unused production capacity in an existing line. The assignment of the plant-level costs receives much attention, particularly from the managers of the marketing divisions.
They want to verify that these costs do indeed stay ‘fixed’ and don’t creep upward each period. The marketing managers make sure that increases in plant-level costs occur only when they request a change in production capacity. Marketing managers now distinguish between products that cover all manufacturing costs versus those that cover only the unit- and batch-level expenses but not their annual product sustaining and plant-level expenses. Because of the assignment of unused capacity expenses to the responsible marketing division, the marketing managers incorporate information about available capacity when they make decisions about pricing, product mix and product introduction.