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Chapter 22: Problem 11

What is one potential limitation of full-cost-based transfer prices?

Short Answer

Expert verified
Full-cost-based transfer prices can reduce cost control incentives and lead to suboptimal internal decision-making.

Step by step solution

01

Understanding Full-Cost-Based Transfer Prices

Full-cost-based transfer pricing involves setting the transfer price equal to the total cost of producing the goods or services. This method includes direct costs, such as materials and labor, as well as indirect costs or overhead.
02

Exploring Managerial Incentives

When using full-cost-based transfer prices, managers might not be motivated to control costs effectively because the transfer price includes all costs, even if some could be reduced. This approach can lead to reduced efforts in cost efficiency.
03

Potential Loss of Profitability Focus

Since full-cost-based transfer pricing does not account for market conditions or profitability, divisions within a company might sell goods at a transfer price that is not competitive in the market. This situation might make it difficult for divisions to achieve profitability targets.
04

Analyzing Internal Decision-Making

The use of full-cost transfer prices may distort internal performance measurements, leading to suboptimal decision-making. Divisions might make decisions that are beneficial internally but potentially harmful to the company's overall financial health.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Managerial Incentives
In a business setting, understanding the impact of transfer pricing on managerial incentives is crucial. When companies use full-cost-based transfer pricing, managers might lack the motivation to keep costs down. This is because the transfer price paid by buying divisions includes all production costs. Even if reducing some costs is possible, the effort to do so might not be pursued. Here's why:
  • Managers might feel secure knowing that all incurred costs are covered by the transfer price.
  • This can lead to an attitude of complacency, where cost-saving opportunities are overlooked or ignored.
  • Ultimately, without the pressure to increase efficiency, the overall operational costs might remain high.
Consequently, for effective managerial incentives, companies might need to consider alternative pricing methods that encourage cost control.
Profitability Focus
Aligning business operations with profitability objectives is essential. However, full-cost-based transfer pricing can obscure this focus considerably. The method emphasizes covering costs without considering market dynamics:
  • There is a disconnection from real market prices, which might be lower than the internally transferred price.
  • This practice can lead divisions to miss out on pricing competitiveness in the market, affecting their sales positively.
  • Divisions may sell at suboptimal prices that don't reflect current market demand conditions, hindering growth.
Thus, companies sometimes need to integrate market-based elements into transfer prices to ensure internal transactions align with broader profitability goals.
Internal Decision-Making
Internal decision-making is a critical aspect that ensures a company's efficiency and success. However, full-cost-based transfer pricing can distort this process. Here's how:
  • It might lead to skewed performance metrics, where divisions seem to perform well financially even if the reality is different.
  • Managers might make decisions based on internal profit figures rather than the actual health of the business.
  • This can result in suboptimal resource allocation, where divisions prioritize internal gains over what's best for the company as a whole.
Thus, to foster more sound internal decision-making, companies might find more value in using pricing strategies that factor in both internal efficiency and external market realities.

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Most popular questions from this chapter

Jackson Markets, a chain of traditional supermarkets, is interested in gaining access to the organic and health food retail market by acquiring a regional company in that sector. Jackson intends to operate the newly-acquired stores independently from its supermarkets. One of the prospects is Health Source, a chain of twenty stores in the mid- Atlantic. Buying for all twenty stores is done by the company's central office. Store managers must follow strict guidelines for all aspects of store management in an attempt to maintain consistency among stores. Store managers are evaluated on the basis of achieving profit goals developed by the central office. The other prospect is Harvest Moon, a chain of thirty stores in the Northeast. Harvest Moon managers are given significant flexibility in product offerings, allowing them to negotiate purchases with local organic farmers. Store managers are rewarded for exceeding self-developed return on investment goals with company stock options. Some managers have become significant shareholders in the company, and have even decided on their own to open additional store locations to improve market penetration. However, the increased autonomy has led to competition and price cutting among Harvest Moon stores within the same geographic market, resulting in lower margins. 1\. Would you describe Health Source as having a centralized or a decentralized structure? Explain. 2\. Would you describe Harvest Moon as having a centralized or a decentralized structure? Discuss some of the benefits and costs of that type of structure. 3\. Would stores in each chain be considered cost centers, revenue centers, profit centers, or investment centers? How does that tie into the evaluation of store managers? 4\. Assume that Jackson chooses to acquire Harvest Moon. What steps can Jackson take to improve goal congruence between store managers and the larger company?

Describe three criteria you would use to evaluate whether a management control system is effective.

Jeremiah Industries manuractures high-grade alu minum luggage made from recycled metal. The company operates two divisions: metal recycling and lug gage fabrication. Each divivision operates as a decentralized entity. The metal recycling divisision is free to sell sheet aluminum to outside buyers, and the luggage fabrication division is free to purchase recycled sheet aluminum from other sources. Currently, however, the recycling divisision sells all of its outruut to the fabrica tion divisision, and the fabrication divisision does not purchase materials from any outside suppliers. Aluminum is transferred from the recycling division to the fabrication division at \(110 \%\) of full cost. The recycling division purchases recyclable aluminum for \(\$ 0.50\) per pound. The division's other variable costs equal \(\$ 2.80\) per pound, and fixed costs at a monthly production level of 50,000 pounds are \(\$ 1.50\) per pound. During the most recent month, 50,000 pounds of aluminum were transferred between the two divisions. The recycling division's capacity is 70,000 pounds. Due to increased demand, the fabrication division expects to use 60,000 pounds of aluminum next month. Metalife Corporation has offered to sell 10,000 pounds of recycled aluminum next month to the fabrication division for \(\$ 5.00\) per pound. 1\. Calculate the transfer price per pound of recycled aluminum. Assuming that each division is considered a profit center, would the fabrication manager choose to purchase 10,000 pounds next month from Metalife? 2\. Is the purchase in the best interest of Jeremiah Industries? Show your calculations. What is the cause of this goal incongruence? 3\. The fabrication division manager suggests that \(\$ 5.00\) is now the market price for recycled sheet aluminum, and that this should be the new transfer price. Jeremiah's corporate management tends to agree. The metal recycling manager is suspicious. Metalife's prices have always been considerably higher than \(\$ 5.00\) per pound. Why the sudden price cut? After further investigation by the recycling division manager, it is revealed that the \(\$ 5.00\) per pound price was a one-time-only offer made to the fabrication division due to excess inventory at Metalife. Future orders would be priced at \(\$ 5.50\) per pound. Comment on the validity of the \(\$ 5.00\) per pound market price and the ethics of the fabrication manager. Would changing the transfer price to \(\$ 5.00\) matter to Jeremiah Industries?

"Organizations typically adopt a consistent decentralization or centralization philosophy across all their business functions." Do you agree? Explain.

The Bosh Corporation makes and sells 20,000 multisystem music players each year. Its assembly division purchases components from other divisions of Bosh or from external suppliers and assembles the multisystem music players. In particular, the assembly division can purchase the CD player from the compact disc division of Bosh or from Hawei Corporation. Hawei agrees to meet all of Bosh's quality requirements and is currently negotiating with the assembly division to supply 20,000 CD players at a price between \(\$ 44\) and \(\$ 52\) per CD player. A critical component of the CD player is the head mechanism that reads the disc. To ensure the quality of its multisystem music players, Bosh requires that if Hawei wins the contract to supply CD players, it must purchase the head mechanism from Bosh's compact disc division for \(\$ 24\) each. The compact disc division can manufacture at most 22,000 CD players annually. It also manufactures as many additional head mechanisms as can be sold. The incremental cost of manufacturing the head mechanism is \(\$ 18\) per unit. The incremental cost of manufacturing a CD player (including the cost of the head mechanism) is \(\$ 30\) per unit, and any number of CD players can be sold for \(\$ 45\) each in the external market. 1\. What are the incremental costs minus revenues from sale to external buyers for the company as a whole if the compact disc division transfers 20,000 CD players to the assembly division and sells the remaining 2,000 CD players on the external market? 2\. What are the incremental costs minus revenues from sales to external buyers for the company as a whole if the compact disc division sells 22,000 CD players on the external market and the assembly division accepts Hawei's offer at (a) \(\$ 44\) per \(\mathrm{CD}\) player or (b) \(\$ 52\) per \(\mathrm{CD}\) player? 3\. What is the minimum transfer price per CD player at which the compact disc division would be willing to transfer 20,000 CD players to the assembly division? 4\. Suppose that the transfer price is set to the minimum computed in requirement 3 plus \(\$ 2\), and the division managers at Bosh are free to make their own profit-maximizing sourcing and selling decisions. Now, Hawei offers 20,000 CD players for \(\$ 52\) each. a. What decisions will the managers of the compact disc division and assembly division make? b. Are these decisions optimal for Bosh as a whole? c. Based on this exercise, at what price would you recommend the transfer price be set?
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