INTERNAL TRANSFER PRICING

THE NEW BRUNSWICK COMPANY

COMPANY BACKGROUND
midsized subsidiary of the Sun Corporation

manufacturers various textile and similar material composites

Sales are made to affiliate companies as well as to external companies

MISSION
to develop and supply unique, cost effective fabrics and related non conventional structures to proactively support the Sun Corporation's worldwide consumer and professional market to capitalize on the resultant unique product and fabric capabilities by developing profitability franchises in selective growth-oriented consumer and industrial markets

THE PRODUCT
Super Weave

Originally developed by Smith Company a competitor

Sanitech - responsible for asepsis within the operating room. Sanitech markets operating room apparel, gloves, and disinfectants. Ten years ago, Sanitech began marketing operating room packs and gowns using the Smith fabric

DRAWBACKS
1. Product improvements made by Smith might not be exclusive to Sanitech in the future, because Smith could sell to Sanitech's competitors. 2. Smith's capacity versus Sanitech's demand. 3. Lack of a second source. 4. Fear of monopolistic pricing practices.

NEW BRUNSWICK'S ENTRY INTO THE MARKET

developed a material equivalent to the Super Weave fabric for sale to Sanitech

significant capital investment in plant and equipment - $30 million

Sanitech - was at liberty to select the fabric that, from its perspective, would best meet its customers' requirements at the lowest cost

SMITH'S RESPONSE
Smith's prices to Sanitech immediately dropped.

Smith introduced pricing strategies that rewarded Sanitech for high volume and provided multiyear incentives
Sanitech and Smith had developed an effective partnership Smith had been able to maximize manufacturing efficiencies and achieve lower cost

NEW BRUNSWICK'S PROBLEM

The vice president of affiliate marketing at New Brunswick requested the assistance of the chief financial officer in developing a plan that would enable New Brunswick to sell its product to Sanitech while achieving the following objectives: 1. Establish a price that is competitive while recovering the capital investment in a reasonable number of years.

2. Establish the longer-term profitability for New Brunswick.

3. Provide the corporation with the lowest-cost product over the long run.

METHOD OF CALCULATING TRANSFER PRICES

Market-based pricing method
organization that uses this method price the goods and services they transfer between their profit centers at a level equal to the prevailing open market price for those goods and services.

Advantages:
The division can operate as independent profit centers with the managers of these units being completely responsible for performance of their business units. This increases their motivation Makes it easy for the top management to assess the performance of the individual divisions. Tax and custom authorities favor market price method as it is transparent and they can cross check the price details provided by the organization by comparing them with market prices on that date. Problems: There is no competitive market which can provide comparable price. There is variation in the prices between one market and another due to difference in exchange rates, transportation cost, local taxes and tariffs etc.

METHOD OF CALCULATING TRANSFER PRICES

Negotiated pricing method
In this method of transfer pricing , the buying and selling division negotiate a mutually acceptable transfer prices. Since each division is responsible for its own performance, this will encourage cost minimization and encourage the parties to seek a transfer price that yields them an appropriate return. Tax authorities have reservation about this method because it gives organization greater scope to manipulate the transfer prices and thus minimize their tax liability.

Cost plus method

It is the simplest method of transfer pricing is to use full historical cost. The full cost of product is material , labor and overhead cost required to produce and ship the product to the buying unit. Full costs are the most economical transfer prices to develop because they are routinely prepared for inventory evaluation. However if the goods are transferred at cost then the selling division is only a cost center, or profit center budgeted at zero profitability if standard costs are used as the transfer prices. Some firms have attempted to use simple cost based transfer prices yet provide for profit by adding a normal markup to cost. This method produce artificial profit system which is dictated by corporate policy on markups rather than by market forces.

METHOD OF CALCULATING TRANSFER PRICES

Marginal cost
the marginal cost of a unit is the additional cost required to produce it.
If the transfer pricing system is designed to ensure efficient allocation of resources than the best transfer price to use is marginal cost. Decision making based on incremental cost determines the benefits of the decision for the organization as a whole. At less than full capacity, marginal cost consist of the variable costs of producing and shipping goods plus any cost directly associated with the transfer. At full capacity , however incremental cost must reflect the opportunity lost by foregoing sales to outside customers. In this situation, incremental cost is equal to market prices.

HOW SHOULD NEW BRUNSWICK DEVELOP ITS PRICING STRATEGY

HOW SHOULD THE BENEFIT TO THE SUN CORPORATION BE MEASURED

WHAT MIGHT SMITH'S REACTION BE TO YOUR STRATEGY

SHOULD VERTICALLY INTEGRATED CORPORATIONS BE FORCED TO PROCURE RAW MATERIALS FROM OTHER DIVISIONS

SHOULD INTER-COMPANY PRICING POLICY BE INFLEXIBLE