s 1 Using the data provided, explain Paul Giddings' misgivings about a transfer price of 12.50. Indicate the actions he may take to source his rubber hose requirements and identify those which are in BBR's best interests. 2 Analyse the transfer-pricing procedure of BBR within the management-control system (Exhibit 401.2). Outline clearly all the hidden costs associated with the existing procedure. 3 Suggest and examine alternative transfer-pricing procedures and transfer prices which may lead to an improvement. PART IV Case study problems Case 401 BBR plc Clive Emmanuel, University of Glasgow This case highlights a transfer-pricing problem where divisional interests are pitted against total corporate profitability. The case requires some analysis of the potential costs and benefits of a transfer-pricing procedure based on divisional management negotiation. 'BBR prides itself on being a growing, prosperous company, its success being partly due to a good management team which fully participates in its development via a decentralised control system.' This statement was questioned at the meeting which took place between John North, group finance director of BBR and Paul Giddings, divisional general manager of the Shrewsbury plant. The surprise came when Paul revealed that he did not believe he was responsible for his division's profitability. This, he claimed, was due to the company's transfer-pricing policy. Historically, Paul's division bought over 50% of its total input of rubber hose from a sister division located in Preston. This trade annually accounted for about 25-35% of the Preston divi- sion's total output. Paul felt that the transfer price was unfair, and hence his division's reported profit was not a true reflection of his operational effectiveness. In the ensuing conversation both men agreed in principle that divisional general managers are delegated discretionary control over short-term strategy development, day-to-day operating decisions and capital expenditure deci- sions up to a prescribed limit. However. Paul claimed that in practice other factors intervened to reduce the divisional manager's degree of control and took, as an example, the inter-divisional trade in rubber hose. The rubber hose trade Fundamentally, the Preston division produces rubber hose which is then sold to, among others, Paul's Shrewsbury division where it is 'tailored' for hydraulic uses in pit props, aircraft undercar- riages and heavy plant and equipment. Before the annual budgets are compiled, the divisional general managers enter into negotia- tions about fixing the transfer price. Three months' notice is required before any mutually agreed price can be revised. The managers themselves spend one or two days negotiating the transfer price for the forthcoming months. At this meeting, information provided by their respective man- Source: Emmanuel, C.R. (1988) 'BBR plc', in D. Otley, D. Brown and C. Wilkinson (eds) Case Studies in Management Accounting (Hemel Hempstead, UK: Philip Allan Publishers). Reproduced with permission. Case 401 617 Exhibit 401.1 provides cost data which the managers are using in their current negotiations. The transfer price proposed by the Preston division is 12.50 per metre of rubber hose. Exhibit 401.1 Cost data available for the transfer-pricing negotiations Preston Division Output ('000 metres of rubber hose) Average material cost ( per metre) Average direct labour cost ( per metre) 100 8.00 5.00 200 7.70 4.80 300 7.50 4.70 400 7.20 4.50 500 7.00 4.10 600 6.50 4.00 700 6.00 3.80 800 5.50 3.60 900 5.00 1000 4.50 3.40 3.20 Annual budgeted divisional fixed costs Annual budgeted allocation of selling, administration and 160 000 40 000 transportation costs Proposed transfer price Shrewsbury Division 12.50 per metre 100 200 300 400 500 Buy-in order size ('000 metres of rubber hose) ( per metre) 14 Average external suppliers list price Average discount (% per metre) nil 14 14 14 14 3.57 7.15 11.6 15.0 Overlaying all of this is the difficulty both parties have in trying to forecast whether the future market will exhibit excess demand or excess supply. It is this problem which had led to the regular revision of the transfer price during the budget year in which it has been set. Questions 1 Using the data provided, explain Paul Giddings' misgivings about a transfer price of 12.50. Indicate the actions he may take to source his rubber hose requirements and identify those which are in BBR's best interests. 2 Analyse the transfer-pricing procedure of BBR within the management-control system (Exhibit 401.2). Outline clearly all the hidden costs associated with the existing procedure. 3 Suggest and examine alternative transfer-pricing procedures and transfer prices which may lead to an improvement. 618 1 BATO Case study problems Exhibit 401.2 Procedures governing transfer-price setting A Policy 1 The transfer price between operating units of the same operating company is purely a matter for the Chief Executive of the operating company concerned, for he is responsible for the total profitability of the organisation under his management. However, where supply/ demand is between operating units of the same operating company it is important that a check is maintained on the market, or 'going' price for the products/services in question to enable the efficiency of the supplier to be reviewed. 2 Transfer prices, where applicable, will be between operating companies/units who are organ- isationally separate, i.e. those who are an independent operating unit not within an operating company or who are within a different operating company to the unit with whom they are dealing. 3 Operating companies/units will normally draw their requirements from within Group resources except where: a fiscal/political constraints make this impossible b added cost (e.g. freight, transport, duty, etc.) make the price wholly uncompetitive c the supplying operating unit requires a transfer price in excess of that actually paid by the purchasing operating unit to third parties for 25% of their annual consumption for comparable quality, delivery and quantities of the product in question. B Guidelines 4 Transfer prices agreed between supplying operating units and purchasing operating units will have reference to the market price on the willing buyer/willing seller basis for the compara- ble qualities and deliveries. 5 The agreed quantities and prices of products to be transferred between operating companies to be clearly and separately shown in the documentation submitted by each operating com- pany. 6 It is not in the interests of the Group for the purchasing operating units to play off a Group supplier against a third party; such action serves to debase the whole market price where significant quantities are involved. C Reference 7 If the purchasing operating unit is unable to arrive at an agreed transfer price with the supplying operating unit and where the quantities of products involved are in excess of 10 000 p.a., the matter will be referred to the Headquarters Office, in which event the Chief Executive (or the executive concerned) of the purchasing operating unit will be expected to show that: a he can buy on a regular basis (NOT spot lots) at significantly lower prices than his col- league is offering b he is unable to maintain the gross margins that he has heretofore achieved, or, if selling retail, his standard mark-up inclusive of quantity or special discounts c his operations are seriously prejudiced by his having to accept an inflated transfer price from Group resources. 27 Case 401 619 8 It will be important that (a) a firm supply/demand plan is established and (b) the buying operating unit can rely on the same quality and service which is available to them from third parties. Thus the provision contained in para. 5 (i.e. that the planned Inter-Group Transfer Price is shown in the documentation, working programme section and represents the basis on which both parties are operating) will establish a quasi-contractual situation between the parties concerned. 9 If operating unit A erects a plant for the purpose of supplying operating unit B then clearly B is committed to accepting the planned transfer price over the planned time scale, while A is responsible for ensuring that its output costs are in accordance with the original plan submit- ted in the sanction documents. D Conclusion 10 Nothing in the foregoing will be interpreted as an intention that one operating unit should subsidise inefficient (in quality) or uneconomic (in cost) production of another; it is intended that the policy set out in paras 2 and 3 above shall be complied with in order that maximum throughput at transfer prices which will optimise the total Group profita- bility can be achieved