Medoc Company is faced with some problems in its transfer pricing policy between 2 of its 15 investment centres within the firm, namely the Milling Division and the Consumer Products Division. The transfer price set by the firm actually created some friction between these 2 divisions. Dealing with warehousing, shipping, billing, advertising and other sales promotion efforts for the consumer products and a fraction of the flour produced by the Milling Division, the Consumer Products Division complained that it was charged an inappropriate cost for all the items transferred from the Milling Division and thus it had little motivation to pursue more aggressive marketing efforts given that it had to do it at the expense of reducing its own average profit margin. And there are still several other complaints from the Consumer Products Division in relation to this as well. The transfer price charged to the Consumer Products Division was based on the full cost approach where every unit was charged at actual cost including material, labour, variable overhead and non-variable overhead with an additional charge of 75 percent of the investment in Milling Division. This caused three main identifiable problems: Managers’ goals are not aligned with the company’s goal as the cost behaviour is altered after transferring to the Consumer Products Division. Consumer Products Division's is charged 75 percent of investment of Milling Division despite the fact that they had no control over Milling Division. The inefficiencies of the Milling Division could be passed on to the Consumer Products Division through the transfer prices charging at actual cost. To solve these problems, the firm had examined different transfer pricing approaches but it was hard to decide on which method to use due to the different compositions of the products and the market price of is not readily available and could not be measured accurately. Also, the top management wants profit of the two divisions measured separately, hence combining the two divisions for profit reporting purposes had been ruled out. Given the situation, a tentative suggestion has been made. The proposed method was that the transfer price should consist of 2 elements. One is the variable cost which will comprise the actual material, labour and variable overhead costs applied to each unit and the other is a standard monthly charge representing the Consumer Products Division's “fair” share of the non-variable overhead on the fraction of the products transferred and a return of 10 percent on the same fraction of the Milling Divisions investment. Ideal Situation
In order to see what changes could be made to improve the transfer price mechanism, the ideal situation is considered. Working towards the ideal will definitely help reduce the problems faced. Ideally, managers should be far sighted, taking care of the long run as well as short run performances of their responsibility centres. The staff involved in negotiation and arbitration must also be competent. Secondly, there must be good atmosphere where managers perceive the transfer prices are fair. Next, the ideal transfer price is based on a well-established, normal market price for identical product being transferred. Alternatives for sourcing should also exist where buying manager can buy from a third party and selling manager is also free to sell to a third party. Managers should have access to full information about the available alternatives and the relevant costs and revenues of each. Lastly, there must be a smooth working mechanism for negotiating "contracts" between business units. These ideal conditions will induce goal congruent decisions in the transfer price system. Thus, they shall be referred to as a guide in our recommendations.
Recommendation with Organizational Structure Constraints
Thus, our solution is aimed to solve the problems noted above. We propose to use a...