Arya Print Products: Transfer Pricing

Arya Print Products is a subsidiary of Stark Systems. Stark Systems is a multi-national information systems consulting firm. Arya has traditionally provided all of the promotional pamphlets, bound reports, and professional presentation materials used by all of the divisions within Stark Systems.

For the past three months, designers with Arya Print Products have been working with consultants from Sansa Consulting, another division of Stark Systems. This team has been working to design promotional materials that Sansa Consulting will distribute to past and potential clients. The designers for Arya Print Products have worked a total of 1,000 person-hours on this design task. Sansa Consulting has reimbursed Arya Print

Products on a cost-plus basis the $30,000 labor cost of the designers (1,000 hours $30 per hour) plus a small profit markup of 10% for a total reimbursement of $33,000 ($30,000 + $3,000).

With the design completed, Sansa Consulting has asked for bids to do the actual production of the promotional materials. Sansa has received two bids.

From Arya Print Products $1,000,000

From Outside Print and Graphics 800,000

The division manager for Sansa Consulting wants to accept the $800,000 bid from Outside Print and Graphics which is not affiliated with Stark Systems. The division manager of Arya Print Products has refused to lower her bid.

For the past year, Aryas operations have run, on average, at 60% of full capacity. The division manager of Arya Print Products reports that $1,000,000 is the market price of this job given the premium quality that her division produces. She also reports that she thinks the $800,000 bid from Outside Print and Graphics represents a one-time, low-ball bid from a low-quality producer. Finally, the Arya manager estimates that her direct production cost for this job is $790,000, as follows: $400,000 for materials, $225,000 for labor, and $165,000 for direct overhead. [Arya would buy the materials for $400,000 from yet a third Stark Systems division, Brandon Raw Materials. The cost to Brandon of buying these materials would be $250,000, so Brandon would mark the materials up by $150,000 before selling them to Arya.]

Within Stark Systems, all division managers are evaluated based on the amount of segment margin generated by her or his division. Segment margin is defined as revenue minus variable cost minus direct fixed cost. A simple organization chart for Stark Systems is given below.

Questions:

1. (40 points) From the standpoint of Stark Systems (the parent company),

a. What is the total out-of-pocket cost (assuming all costs paid in cash) for the production of the promotional materials if Sansa Consulting buys the promotional materials from Outside Print and Graphics (a company unaffiliated with the Stark Systems group) (10 points)?

b. What is the total out-of-pocket cost (assuming all costs paid in cash) for the production of the promotional materials if Sansa Consulting buys the promotional materials from Arya Print Products? List all the decomposition of the out of pocket cost. (Hint: ignore the effect of transfer pricing and consider the company as a whole) (10 points)

Assume that you are Stark Systems commercial vice-president (the direct superior of the managers of the Arya and Sansa divisions).

c. What if the Vice-President FORCES Sansa to accept the $1,000,000 in-house bid? List the change in segment margin for the company as a whole and by subsidiaries compared with Sansa accepting the outside bid. (10 points)

d. What if the Vice-President FORCES Arya to match the $800,000 outside bid? In this case, List the change in segment margin for the company as a whole and by subsidiaries compared with Sansa accepting the outside bid. (10 points)

2. (25 points) Assume that you are the division manager of Sansa Consulting. You have received two bids for the production of the promotional materials that you need:

• $800,000 from Outside Print and Graphics (a company unaffiliated with the Stark Systems group)
• $1,000,000 from Arya Print Products

1. What will happen to your division segment margin if you accept the $1,000,000 Arya Print Products bid instead of the $800,000 Outside bid? (8 points)

2. Which one of the two bids should you accept? Explain. (8 points)

3. Do you have any concerns if you act according b.? Explain. (9 points)

3. (25 points) Assume that you are the division manager for Arya Print Products.

1. What will happen to your division segment margin if you lower your bid to $800,000? (8 points)

2. Should you consider lowering your bid to $800,000 in order to match the bid from the outside company? Explain. (8 points)

3. What factors might make you reluctant to lower your bid to $800,000? Explain. (9 points)

4. (10 points) The problem in this case is that the decentralized managers of Arya and Sansa, each acting in the best interest of her or his individual division, might not make a collective decision that is in the best interest of Stark Systems as a whole. Can better ACCOUNTING solve this problem? If so, how? If not, why not? (10 points)