Explain the potential behavioural issues that may arise in the application of performance monitoring, budgeting and transfer pricing and suggest how problems may be overcome.
(1) Performance Monitoring
There is a general acceptance of the idea that an organisation that monitors performance and rewards individuals for ‘good performance’ is more likely to encourage behaviour that is consistent with the objectives of the organisation. This involves the organisation ‘transmitting signals’ to its people as to what it deems desirable activities and outcomes in the workplace. This approach has resulted in such terms and activities as performance monitoring, performance related pay, payment by results, bonus systems. The reward for the achievement of desired outcomes could be money, promotion, job security, preferred work activities, alternative work environments. Unfortunately this is a very complex task and problems are likely to arise in a number of areas:
It is very difficult in many work environments to measure individual performance – and if you resort to team performance, it is difficult to gauge the contribution from individual members.
It is difficult to ensure that individual targets are not inconsistent with other individuals or corporate objectives.
Current measured performance may discourage consideration of longer term issues that may have adverse repercussions.
Can a performance monitoring system comprehensively measure the key variables? For example, the desire to achieve greater volume/activity may be at the cost of quality that is more difficult to identify and appraise.
Measure fixation – concentrating on the measurement process and not on what needs to be achieved.
Misrepresentation – ‘creative’ responses that give a favourable view of activities.
Myopia – short sighted viewpoint with limited consideration to long term issues.
The problems highlighted above can be managed if the following points are considered:
Do not underestimate the scale of the task in designing a performance monitoring system.
Consider the expectations and likely responses of all the parties concerned – take a broad view.
Ensure that the people designing and operating the system have a comprehensive understanding of the organisation’s activities and the interrelationship between all of the stakeholders.
Ensure that all parties involved believe that they will be beneficiaries of the system.
Be prepared to reappraise and modify – it is unrealistic to believe that it can be perfected at the first attempt.
(2) Budgeting
Adverse behavioural consequences of budgeting can arise from insufficient consideration being given to the task during the planning stage. The targets set may be perceived as:
Imposed
Complicated
Unfair
Irrelevant
Easy
Unachievable.
This is likely to foster the ‘them and us’ syndrome and the consequential failure to achieve goal congruence.
These undesirable consequences may be avoided by consulting with all interested parties, setting challenging but achievable targets, considering other people’s perception of the targets and anticipating their likely responses. On the other hand, if budget holders are given complete autonomy or are permitted to have a significant influence on budgetary targets, they may be tempted to build in ‘slack’ to give themselves an easy life which is not in the interests of their organisation.
Having implemented the planning stage, we need to turn our attention towards control.Behavioural problems can arise from:
A failure to distinguish between controllable and non-controllable factors for each particular budget holder – people will feel aggrieved for being accountable for what they do not control.
A failure to account for the changing circumstances that have arisen since the budget was determined – may require budget adjustments and/or a flexible budget approach.
Failure to reward favourable variances – budget under spending that automatically results in cuts in future budget provision merely encourages spending of the entire budget, not something that should be encouraged.
Budget constrained approach – a requirement to conform to budget may stifle attempts at improvement.
Insufficient participation in budgetary control and poor communication of the reasons for change decisions may alienate staff.
(3) Transfer Pricing
Transfer pricing is primarily concerned with ensuring that semi-autonomous business units behave in a way that contributes towards the achievement of corporate and not merely divisional objectives. An effective transfer pricing system encourages divisional managers with autonomous decision making authority to pursue the interest of the corporation automatically whilst endeavouring to maximise the performance of their own business unit. Their decisions are made with self (divisional) interest as the driving factor, but coincidentally benefit the entire company. Effective transfer pricing systems consciously endeavour to harness selfish divisional behaviour to induce decisions that foster goal congruence. Problems can arise when inappropriate prices are set that result in ‘wrong signals’ being sent and non-optimal decisions being made:
Too high a price may result in unused capacity, lost contribution, reduced incentive to find external markets and unnecessary external sourcing from the buying division.
Too low a price may result in ‘excessive’ internal trading and a loss of valuable external business.
To avoid these pitfalls the transfer pricing determination should consider:
The cost behaviour (fixed and variable) of the different divisions.
The adequacy of the information available to the divisions concerning both internal and external prices.
Both the short and long run consequences of the prices set – internal and external markets and capacity levels.
The degree of autonomy given to the divisions.
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Tuesday, July 5, 2011
Behavioural Consequences
Explain why it is necessary when designing a management accounting system to consider the behavioural consequences of its application.
The role of a management accountant is to provide information which can be used to assist and guide management in the pursuit and achievement of organisational objectives.
The management information provided is read, interpreted and responded to by people within the organisation, and their responses will determine the quality of the decisions made and the extent to which corporate objectives are achieved.
Management accountants should be aware of this relationship and endeavour to ensure that the information that they supply is used in a way that benefits their organisation.
The design and operation of a management accounting system should anticipate the behavioural consequences that are likely to arise as a result of its activities.
A management accountant who fails to consider these repercussions or denies responsibility for them is likely to operate a dysfunctional system. This is most likely to manifest itself in a failure to secure goal congruence between the interested parties.
The management accounting system will need to consider the particular culture of the organisation, whether it has a hierarchical or democratic structure, its attitude towards employee empowerment and the extent of delegated team decision making.
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The role of a management accountant is to provide information which can be used to assist and guide management in the pursuit and achievement of organisational objectives.
The management information provided is read, interpreted and responded to by people within the organisation, and their responses will determine the quality of the decisions made and the extent to which corporate objectives are achieved.
Management accountants should be aware of this relationship and endeavour to ensure that the information that they supply is used in a way that benefits their organisation.
The design and operation of a management accounting system should anticipate the behavioural consequences that are likely to arise as a result of its activities.
A management accountant who fails to consider these repercussions or denies responsibility for them is likely to operate a dysfunctional system. This is most likely to manifest itself in a failure to secure goal congruence between the interested parties.
The management accounting system will need to consider the particular culture of the organisation, whether it has a hierarchical or democratic structure, its attitude towards employee empowerment and the extent of delegated team decision making.
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Limiting Factor Analysis (LFA) Concept
• For short-run product-mix, decisions with capacity constraints/bottlenecks and the assumed objective is to maximise short-run profits.
• If fixed costs remained unchanged, maximisation of total contribution will result in maximisation of short-run profits.
(A) Single limiting factor analysis - Two approaches:
• Using marginal costing principles
• Using throughput accounting principles – developed for a JIT environment
(B) Multi-limiting factor analysis
A Linear Programming Model using marginal costing principles can be used to determine the profit-maximisation product-mix.
(Key point: Always use marginal costing principles for decisions involving limiting factors. Throughput accounting principles is relevant only if specifically required in the question)
LFA Using Marginal Costing Principles
Decision rule: Rank products based on contribution per unit of the scarce resource/limiting factor.
Contribution = Sales – All Variable Costs
Contribution per unit of scarce resource
= Variable contribution per unit of output / Scarce resources required per unit of output
LFA Using Throughput Accounting Principles
Decision rule: rank products based on throughput accounting ratio (TA ratio)
TA ratio = Throughput contribution per bottleneck hour / Total factory cost per bottleneck hour
Throughput contribution or throughput return = Sales – Direct Material Costs
Total factory cost include all operating costs, except direct materials.
Note: Product ranking using TA ratios is identical to ranking products using throughput contribution per unit of the bottleneck.
TA ratios can be used to measure product profitability in the following context:
• As a relative measure of profitability for ranking products – the higher the ranking, the more profitable is the product.
• As an absolute measure – a product is profitable only if its TA ratio is more than one (1), otherwise not profitable.
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• If fixed costs remained unchanged, maximisation of total contribution will result in maximisation of short-run profits.
(A) Single limiting factor analysis - Two approaches:
• Using marginal costing principles
• Using throughput accounting principles – developed for a JIT environment
(B) Multi-limiting factor analysis
A Linear Programming Model using marginal costing principles can be used to determine the profit-maximisation product-mix.
(Key point: Always use marginal costing principles for decisions involving limiting factors. Throughput accounting principles is relevant only if specifically required in the question)
LFA Using Marginal Costing Principles
Decision rule: Rank products based on contribution per unit of the scarce resource/limiting factor.
Contribution = Sales – All Variable Costs
Contribution per unit of scarce resource
= Variable contribution per unit of output / Scarce resources required per unit of output
LFA Using Throughput Accounting Principles
Decision rule: rank products based on throughput accounting ratio (TA ratio)
TA ratio = Throughput contribution per bottleneck hour / Total factory cost per bottleneck hour
Throughput contribution or throughput return = Sales – Direct Material Costs
Total factory cost include all operating costs, except direct materials.
Note: Product ranking using TA ratios is identical to ranking products using throughput contribution per unit of the bottleneck.
TA ratios can be used to measure product profitability in the following context:
• As a relative measure of profitability for ranking products – the higher the ranking, the more profitable is the product.
• As an absolute measure – a product is profitable only if its TA ratio is more than one (1), otherwise not profitable.
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Information required at board level and to be published, on environmental and social policies
Information required to be supplied at board level would depend on the cmpany’s ongoing attitude to environmental and social issues
Type A Company
Company that the view that environmental and social issues are of no concern
1. The company would therefore only be interested in ensuring that current legal requirements were met and that the cost of adverse publicity was avoided.
2. An individual should become responsible for monitoring social and environmental developments and advise the board if or when the company was required to take additional steps.
3. Disclosure would be kept to a minimum, and would concentrate on practices that were of benefit to the community at large, rather than those that may be of interest to competitors.
Type B Company
Company who are environmental and socially responsible as there is a substantial interest amongst consumers and investment fund managers
1. The company may report on environmental and social issues as part of its competitive strategy.
2. Information required would then increase significantly.
3. A study would need to be conducted into what was considered to be best practice.
4. This would identify the investment requirements of the ethical investment funds and the current thinking on environmental and social issues by the various pressure groups, such as Amnesty International and Greenpeace.
5. The company then establish a formal code of challenging targets (such as 95% of packaging used should be made of recycled materials) to be achieved on these environmental and social issues and report on how these targets were being met.
6. This report could be included as part of the normal reporting package.
7. Areas in which the company was particularly successful and which were not commercially damaging (such as a change in product design) could then be included in the Annual Report.
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Type A Company
Company that the view that environmental and social issues are of no concern
1. The company would therefore only be interested in ensuring that current legal requirements were met and that the cost of adverse publicity was avoided.
2. An individual should become responsible for monitoring social and environmental developments and advise the board if or when the company was required to take additional steps.
3. Disclosure would be kept to a minimum, and would concentrate on practices that were of benefit to the community at large, rather than those that may be of interest to competitors.
Type B Company
Company who are environmental and socially responsible as there is a substantial interest amongst consumers and investment fund managers
1. The company may report on environmental and social issues as part of its competitive strategy.
2. Information required would then increase significantly.
3. A study would need to be conducted into what was considered to be best practice.
4. This would identify the investment requirements of the ethical investment funds and the current thinking on environmental and social issues by the various pressure groups, such as Amnesty International and Greenpeace.
5. The company then establish a formal code of challenging targets (such as 95% of packaging used should be made of recycled materials) to be achieved on these environmental and social issues and report on how these targets were being met.
6. This report could be included as part of the normal reporting package.
7. Areas in which the company was particularly successful and which were not commercially damaging (such as a change in product design) could then be included in the Annual Report.
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Friday, July 1, 2011
PRICING STRATEGY
Pricing strategy is a component of a firm’s product/market development strategy for that product and/or the business as a whole to achieve a competitive advantage.
A firm’s product/market strategy (inclusive of pricing strategy) must be developed in the context of the firm’s chosen generic strategy to maximize its competitive advantages (cost leadership, product differentiation and niche marketing/focus) and how the firm plans to develop the product over time (product-life cycle development)
1. Cost leadership
• Aim to produce the lowest cost and good quality product in the industry.
• Adopts a cost-conscious approach
• Competences - strong technical advantage and low-cost distribution system.
• A low-cost leader will have the ability to lower prices in time of severe competition and enjoy higher profit margins.
• A low-cost leader can defend itself in price wars, attack competitors on price to gain market share.
• Penetration pricing
2. Product differentiation
• Aim to produce products with special and unique attributes that are valued by customer and who is willing to pay for it.
• Strong marketing and promotion to develop customer/brand loyalty.
• Corporate reputation for quality or technological leadership.
• Adopts premium pricing or market skimming pricing
3. Focus/Niche Marketing
• Concentrates on a strategically identified target market segment (e.g. isolated geographical areas, small or medium-sized customers with unique demands)
• The target market segment will determine the choice between a low-cost base or a differentiation-base.
4. Product Life-cycle Development and Pricing
The price at which a product should be sold is not a one-time, once and for all decision. For example the price will need to be modified over time as the product passes through the various stages of its life-cycle:
• Introduction – high price skimming or penetration pricing
• Growth – gradual price reductions or gradual price increases
• Maturity / saturation – savage price cutting / price wars
• Decline – price decreases.
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A firm’s product/market strategy (inclusive of pricing strategy) must be developed in the context of the firm’s chosen generic strategy to maximize its competitive advantages (cost leadership, product differentiation and niche marketing/focus) and how the firm plans to develop the product over time (product-life cycle development)
1. Cost leadership
• Aim to produce the lowest cost and good quality product in the industry.
• Adopts a cost-conscious approach
• Competences - strong technical advantage and low-cost distribution system.
• A low-cost leader will have the ability to lower prices in time of severe competition and enjoy higher profit margins.
• A low-cost leader can defend itself in price wars, attack competitors on price to gain market share.
• Penetration pricing
2. Product differentiation
• Aim to produce products with special and unique attributes that are valued by customer and who is willing to pay for it.
• Strong marketing and promotion to develop customer/brand loyalty.
• Corporate reputation for quality or technological leadership.
• Adopts premium pricing or market skimming pricing
3. Focus/Niche Marketing
• Concentrates on a strategically identified target market segment (e.g. isolated geographical areas, small or medium-sized customers with unique demands)
• The target market segment will determine the choice between a low-cost base or a differentiation-base.
4. Product Life-cycle Development and Pricing
The price at which a product should be sold is not a one-time, once and for all decision. For example the price will need to be modified over time as the product passes through the various stages of its life-cycle:
• Introduction – high price skimming or penetration pricing
• Growth – gradual price reductions or gradual price increases
• Maturity / saturation – savage price cutting / price wars
• Decline – price decreases.
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PRICING POLICY FOR NEW PRODUCTS
A new product pricing strategy will depend largely on whether a company's product or service is the first of its kind on the market.
Totally new products create problems with pricing as there is no information on which to base the price.
If the product is the first of its kind, there will be no competition yet, and the company, for a time at least, will be a monopolist. Monopolists have more influence over price and are able to set a price at which they think they can maximise their profits. A monopolist's price is likely to be higher, and his profits bigger, than a company operating in a competitive market.
There are two basic strategies:
1. Penetration pricing.
2. Market skimming.
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If the new product being launched by a company is following a competitor's product on to the market, the pricing strategy will be constrained by what the competitor is already doing.
The strategies available here are:
1. Penetration pricing.
2. Average or going rate pricing.
3. Discount pricing.
4. Premium pricing.
(1) Penetration Pricing
Market penetration – a policy of low prices when a product is initially launched in order to obtain a high penetration into the market i.e. to gain rapid acceptance of the product.
The circumstances that favour a penetration policy are as follows:
• If the firm wishes to discourage competitors from entering into the market.
• If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.
• If there are significant economies of scale to be achieved from high-volume output, and so a quick penetration into the market is desirable in order to gain those unit cost reductions.
• If demand is highly elastic and so would respond well to low prices.
•
For penetration pricing to be effective, the total market in which the firm is operating must be substantial, and the anticipated market share significant.
(2) Market Skimming
Market skimming involves high prices and high promotion costs when the product is launched to obtain sales.
Market skimming is an attempt to exploit those sections of the market that are relatively insensitive to price changes. Initially high prices may be charged to take advantage of the novelty appeal of a new product when demand is initially inelastic.
Conditions suitable for a market skimming policy are:
• Where the product is new and different, so that customers are prepared to pay high prices so as to be ‘one-up’ on other people who do not own one.
• Where the strength of demand and the sensitivity of demand to price are unknown. It is much easier to lower prices than to increase them. From a psychological point of view it is far better to begin with a high price, which can then be lowered if the demand for the product appears to be more price sensitive than at first thought.
• Where high prices in the early stages of a product's life might generate high initial cash flows. A firm with a liquidity problem may prefer market skimming for this reason.
• Where products have a short life cycle, and so need to recover their development costs and make a profit quickly.
With high prices being charged potential competitors will be tempted to enter the market. For skimming to be sustained, one or more significant barriers to entry must be present to deter these potential competitors. Examples include patent protection, prohibitively high capital investment, or unusually strong brand loyalty.
A skimming policy offers a safeguard against unexpected future increases in costs, or a large fall in demand after the novelty appeal has declined. Once the market becomes saturated the price can be reduced to attract that part of the market that has not been exploited.
(3) Average or Going-rate Pricing
In a competitive market, where there are many suppliers of homogeneous products, and the new product does not differ (and cannot be differentiated sufficiently by marketing means), in terms of quality or design, from existing products, then the firm has little choice but to charge the 'going-rate'. Departure from this price will lead to losses.
(4) Discount Pricing
Discount pricing is where products are priced lower than the market norm, but are put forward as being of comparable quality.
The aim is that the product will procure a larger share of the market than it might otherwise do, thereby counteracting the reduction in selling price.
However, care must be taken to ensure that potential customers' perceptions of the product are not prejudiced by the lower price. The consumer will often view with suspicion a branded product that is priced at even a small discount to the prevailing market rate.
(5) Premium Pricing
In most situations, the new product will either differ, or be made to appear different, in a way that will justify a premium over competing products thereby covering the additional production or marketing costs.
(6) Differential pricing – exists where it is possible to charge different prices for the same product to different customers. The bases on which price discrimination can operate are as follows:
• by product version
• by time
• by place (geographical location)
• by market segment (type of customer)
• by order size
• by age
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Totally new products create problems with pricing as there is no information on which to base the price.
If the product is the first of its kind, there will be no competition yet, and the company, for a time at least, will be a monopolist. Monopolists have more influence over price and are able to set a price at which they think they can maximise their profits. A monopolist's price is likely to be higher, and his profits bigger, than a company operating in a competitive market.
There are two basic strategies:
1. Penetration pricing.
2. Market skimming.
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If the new product being launched by a company is following a competitor's product on to the market, the pricing strategy will be constrained by what the competitor is already doing.
The strategies available here are:
1. Penetration pricing.
2. Average or going rate pricing.
3. Discount pricing.
4. Premium pricing.
(1) Penetration Pricing
Market penetration – a policy of low prices when a product is initially launched in order to obtain a high penetration into the market i.e. to gain rapid acceptance of the product.
The circumstances that favour a penetration policy are as follows:
• If the firm wishes to discourage competitors from entering into the market.
• If the firm wishes to shorten the initial period of the product's life cycle in order to enter the growth and maturity stages as quickly as possible.
• If there are significant economies of scale to be achieved from high-volume output, and so a quick penetration into the market is desirable in order to gain those unit cost reductions.
• If demand is highly elastic and so would respond well to low prices.
•
For penetration pricing to be effective, the total market in which the firm is operating must be substantial, and the anticipated market share significant.
(2) Market Skimming
Market skimming involves high prices and high promotion costs when the product is launched to obtain sales.
Market skimming is an attempt to exploit those sections of the market that are relatively insensitive to price changes. Initially high prices may be charged to take advantage of the novelty appeal of a new product when demand is initially inelastic.
Conditions suitable for a market skimming policy are:
• Where the product is new and different, so that customers are prepared to pay high prices so as to be ‘one-up’ on other people who do not own one.
• Where the strength of demand and the sensitivity of demand to price are unknown. It is much easier to lower prices than to increase them. From a psychological point of view it is far better to begin with a high price, which can then be lowered if the demand for the product appears to be more price sensitive than at first thought.
• Where high prices in the early stages of a product's life might generate high initial cash flows. A firm with a liquidity problem may prefer market skimming for this reason.
• Where products have a short life cycle, and so need to recover their development costs and make a profit quickly.
With high prices being charged potential competitors will be tempted to enter the market. For skimming to be sustained, one or more significant barriers to entry must be present to deter these potential competitors. Examples include patent protection, prohibitively high capital investment, or unusually strong brand loyalty.
A skimming policy offers a safeguard against unexpected future increases in costs, or a large fall in demand after the novelty appeal has declined. Once the market becomes saturated the price can be reduced to attract that part of the market that has not been exploited.
(3) Average or Going-rate Pricing
In a competitive market, where there are many suppliers of homogeneous products, and the new product does not differ (and cannot be differentiated sufficiently by marketing means), in terms of quality or design, from existing products, then the firm has little choice but to charge the 'going-rate'. Departure from this price will lead to losses.
(4) Discount Pricing
Discount pricing is where products are priced lower than the market norm, but are put forward as being of comparable quality.
The aim is that the product will procure a larger share of the market than it might otherwise do, thereby counteracting the reduction in selling price.
However, care must be taken to ensure that potential customers' perceptions of the product are not prejudiced by the lower price. The consumer will often view with suspicion a branded product that is priced at even a small discount to the prevailing market rate.
(5) Premium Pricing
In most situations, the new product will either differ, or be made to appear different, in a way that will justify a premium over competing products thereby covering the additional production or marketing costs.
(6) Differential pricing – exists where it is possible to charge different prices for the same product to different customers. The bases on which price discrimination can operate are as follows:
• by product version
• by time
• by place (geographical location)
• by market segment (type of customer)
• by order size
• by age
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Different Types of Transfer Pricing Methods
For each of the under-noted transfer pricing methods, discuss the market conditions appropriate for their adoption and their limitations.
(i) Market-based transfer prices
(ii) Full-cost based transfer prices
(iii) Negotiated transfer prices
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Market-based Transfer Price
Market conditions which are appropriate for adoption
• Are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs.
• In a perfect market, Selling Division (SD) will be operating at full capacity and can sell whatever quantity of intermediate product it can produce in the external market. In this situation, internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the contribution lost (opportunity cost) from sacrificing external sales should be included in the transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.
• TP=MC+OC = MP
• In a perfect market, the minimum TP is also the maximum TP. Thus, both SD and BD will be happy with a transfer price set as the market price.
• The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price, that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation.
Limitations
(i) As a result of product differentiation, ther may be no comparable product or a single market price.
(ii) Market price may vary because of over-supply or under-supply, promotions, or ‘product dumping’ by foreign competitors.
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Full-cost based Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market, it may be unwise to always set transfer price exactly at the variable costs of production, as such prices do not provide for the replacement of fixed assets.
• The Supply Division (SD) will want to base the transfer price on total absorption cost to ensure that it will provide a contribution to cover the fixed overheads.
• Full-cost based transfer price is widely used because managers require an estimate of long-run marginal cost for decision-making. However, traditional absorption costing systems tend to provide poor estimates of long-run marginal cost for decision-making. ABC will provide better estimates of long run MC.
Limitations
(i) It can lead buying division (BD) to make “sub-optimal” decisions because BD regards the transfer price (which includes the fixed costs) as a wholly variable cost.
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Negotiated Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market (different selling costs for internal and external sales, differential market prices), transfer prices set at the prevailing or planned market price are not optimal i.e. will not induce SD and BD to adopt optimal output level. Central/corporate management intervention is necessary in order to ensure that optimal output levels are set but this process may undermine divisional autonomy.
• In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had been provided with all the information and were educated to use information correctly, it is likely that a negotiated solution would have emerged which would have been acceptable to both the divisions and the group.
• When there is unused capacity, the transfer price range for negotiations generally lied between the minimum price at which SD is willing to sell (its marginal cost) and the maximum price BD is willing to pay (the external supplier price net off any external purchase related costs).
Limitations
(i) Can lead to sub-optimal decisions
(ii) Time-consuming
(iii) Strongly influenced by the bargaining skills and power of the divisional managers
(iv) Inappropriate in certain circumstances (e.g. no market for the intermediate product or an imperfect market exists as the SD will have a bargaining disadvantage)
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(i) Market-based transfer prices
(ii) Full-cost based transfer prices
(iii) Negotiated transfer prices
____________________________________________________________________
Market-based Transfer Price
Market conditions which are appropriate for adoption
• Are generally appropriate in a perfect market, where there is homogeneous product with only one price for both sellers and buyers and no buying or selling costs.
• In a perfect market, Selling Division (SD) will be operating at full capacity and can sell whatever quantity of intermediate product it can produce in the external market. In this situation, internal transfers will result in a need to sacrifice external sales. The benefit forgone that is the contribution lost (opportunity cost) from sacrificing external sales should be included in the transfer price. Thus in this situation TP=MP will be consistent with the general TP rule.
• TP=MC+OC = MP
• In a perfect market, the minimum TP is also the maximum TP. Thus, both SD and BD will be happy with a transfer price set as the market price.
• The adoption of market-based transfer price in a perfectly competitive market meet the criteria of a good transfer price, that is it will promote goal congruent decisions, preserve divisional autonomy and provide an equitable basis for performance evaluation.
Limitations
(i) As a result of product differentiation, ther may be no comparable product or a single market price.
(ii) Market price may vary because of over-supply or under-supply, promotions, or ‘product dumping’ by foreign competitors.
*****************************************************************
Full-cost based Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market, it may be unwise to always set transfer price exactly at the variable costs of production, as such prices do not provide for the replacement of fixed assets.
• The Supply Division (SD) will want to base the transfer price on total absorption cost to ensure that it will provide a contribution to cover the fixed overheads.
• Full-cost based transfer price is widely used because managers require an estimate of long-run marginal cost for decision-making. However, traditional absorption costing systems tend to provide poor estimates of long-run marginal cost for decision-making. ABC will provide better estimates of long run MC.
Limitations
(i) It can lead buying division (BD) to make “sub-optimal” decisions because BD regards the transfer price (which includes the fixed costs) as a wholly variable cost.
**********************************************************
Negotiated Transfer Price
Market conditions which are appropriate for adoption
• In an imperfect market (different selling costs for internal and external sales, differential market prices), transfer prices set at the prevailing or planned market price are not optimal i.e. will not induce SD and BD to adopt optimal output level. Central/corporate management intervention is necessary in order to ensure that optimal output levels are set but this process may undermine divisional autonomy.
• In this situation, it is more appropriate to adopt negotiated transfer prices. If both managers had been provided with all the information and were educated to use information correctly, it is likely that a negotiated solution would have emerged which would have been acceptable to both the divisions and the group.
• When there is unused capacity, the transfer price range for negotiations generally lied between the minimum price at which SD is willing to sell (its marginal cost) and the maximum price BD is willing to pay (the external supplier price net off any external purchase related costs).
Limitations
(i) Can lead to sub-optimal decisions
(ii) Time-consuming
(iii) Strongly influenced by the bargaining skills and power of the divisional managers
(iv) Inappropriate in certain circumstances (e.g. no market for the intermediate product or an imperfect market exists as the SD will have a bargaining disadvantage)
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