PERFORMANCE MANAGEMENT AND CONTROL GROUP ASSIGNMENT THE PRYSM GROUP A TRANSFER PRICING ISSUE

MBA 39 @ SDA Bocconi School of Management, Blue Class - Group 7 Y. Tian, H. Yadav, M. Rossi, G. Perezcasas, G. Sivakumar

Agenda
2

1.
2. 3. 4.

Problem identification
Framework of the alternatives Sourcing decision impact on the three divisions Solution

1. Problem identification
3

The Submarine division of Prysm Group solicited bids for the furniture of the electronic components needed to produce a new cable system, named X73. The quotes were asked to an internal supplier (the Systems division) and two external suppliers (Flying Dutchman and Control Technologies). The choice of the supplier and the transfer pricing alternatives in case of internal production result in different levels of profitability for the Group overall and for the three divisions involved.
Cables division components Systems division

140,000 Electr. controls

Internal production

Submarin e division

340,000 X73 cable

Customer s

100,500 Electr. controls

Control Tech.

External production

Electr. controls 120,500

Flying Dutchman

Agenda
4

1.
2. 3. 4.

Problem identification
Framework of the alternatives Sourcing decision impact on the three divisions Solution

2. Framework
5

We have considered the impact of the different opportunities available to the Prysm Group in order to produce the new X73 cable system. We have also proposed some alternatives of pricing in case of internal production of the electronic components, that can be summarized as follows:
Production of X73 cable

Internally

Externally

At actual TP policy price

At Marketbased TP

At cost plus 2% TP

At full-cost TP

At Variable cost TP

From Flying Dutchman

From Control Technologies

Transfer pricing alternatives

Agenda
6

1.
2. 3. 4.

Problem identification
Framework of the alternatives Sourcing decision impact on the three divisions Solution

3. Sourcing decision impact on the three divisions

7

Analysis of the best sourcing decision for the X73 materials for:

a. The Submarine Division

b. The Systems Division c. The Cables Division d. Prysm Group

a. The Submarine division

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SUBMARINE DIVISION INTERAL PRODUCTION AT ACTUAL TRANSFER PRICING POLICY 340.000,00 - 72.000,00 - 26.300,00 - 140.000,00

EXTERNAL PRODUCTION

MARKET-BASED
340.000,00 - 72.000,00 - 26.300,00 - 110.500,00

COST PLUS 2%
340.000,00 - 72.000,00 - 26.300,00 - 103.795,20

FULL COST
340.000,00 - 72.000,00 - 26.300,00 - 101.400,00

VARIABLE COST
340.000,00 - 72.000,00 - 26.300,00 - 37.400,00

FROM FLYING DUTCHMAN 340.000,00 - 72.000,00 - 26.300,00

FROM CONTROL TECHNOLOGIES 340.000,00 - 72.000,00 - 26.300,00

Revenues (expected) Cost of other components Variable conversion costs Cost of electronic control: - Internal supplier - Flying Dutchman - Control Technologies Contribution margin Fixed conversion costs EBIT ROS (expected)

- 100.500,00 101.700,00 - 117.700,00 - 16.000,00 -5% 131.200,00 - 117.700,00 13.500,00 4% 137.904,80 - 117.700,00 20.204,80 6% 140.300,00 - 117.700,00 22.600,00 7% 204.300,00 - 117.700,00 86.600,00 25% 141.200,00 - 117.700,00 23.500,00 7%

- 120.500,00 121.200,00 - 117.700,00 3.500,00 1%

INTERNAL PRODUCTION: On the basis of actual transfer pricing policies, the Submarine division is expected to suffer a loss. All the other policies would permit to this division to sell at profit. Obviously the most advantageous option for this division is the Variable cost policy. The full cost method would give a similar margin to that gettable from the cheapest external supplier, while with the cost plus 2% method, the margin would be slightly lower. EXTERNAL PRODUCTION: Among the two alternatives, the offer received by Flying Dutchman would be more competitive.

b. The System division

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SYSTEM DIVISION INTERAL PRODUCTION ACTUAL: PRICE TO THE MARKET Revenues Var. COGS: - From Cables division - Others Contribution margin Fixed COGS EBIT ROS 140.000,00 - 21.600,00 - 28.400,00 90.000,00 - 55.000,00 35.000,00 25% MARKET-BASED 110.500,00 - 19.800,00 - 28.400,00 62.300,00 - 55.000,00 7.300,00 7% COST PLUS 2% 103.795,20 - 18.360,00 - 28.400,00 57.035,20 - 55.000,00 2.035,20 2% FULL COST 101.400,00 - 18.000,00 - 28.400,00 55.000,00 - 55.000,00 BREAK-EVEN VARIABLE COST 37.400,00 - 9.000,00 - 28.400,00 - 55.000,00 - 55.000,00 EXTERNAL PRODUCTION - 55.000,00 - 55.000,00

INTERNAL PRODUCTION: On the basis of actual transfer pricing policies (sale at market price), the System division would generate a return on sales of 25%. Considering that it is pricing at a above-average margin and In order to be more competitive, it could propose to sell with a market-based policy, still making a margin of 7%. If this were not sufficient it could sell at cost plus 2%, or at no margin in order to maintain the break-even. As a last resort, the System division could reduce the price even more: the limit that would make the internal production not convenient anymore is Eur 37,400 (equal to the Variable COGS, that would make the Contribution margin equal to 0). EXTERNAL PRODUCTION: Due to the cost structure of the department, characterized by Eur 55,000 of fixed costs, the external production would imply a loss for the System division equal to the aforementioned fixed costs.

c. The Cable division

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CABLE DIVISION INTERAL PRODUCTION ACTUAL: COST PLUS 20% Revenues Var. COGS Contribution margin Fixed COGS EBIT ROS 21.600,00 - 9.000,00 12.600,00 - 9.000,00 3.600,00 17% MARKET-BASED 19.800,00 - 9.000,00 10.800,00 - 9.000,00 1.800,00 9% COST PLUS 2% 18.360,00 - 9.000,00 9.360,00 - 9.000,00 360,00 2% FULL COST 18.000,00 - 9.000,00 9.000,00 - 9.000,00 BREAK-EVEN VARIABLE COST 9.000,00 - 9.000,00 - 9.000,00 - 9.000,00 EXTERNAL PRODUCTION - 9.000,00 - 9.000,00

INTERNAL PRODUCTION: On the basis of actual transfer pricing policies (sale at cost plus 20%), the Cable division would generate a return on sales of 17%. In order to be make the System division more competitive towards the Submarine one, it could accept to sell at the marketbased policy or even at cost plus 2% margin. The price of Eur 18,000 would then be the minimum to get the break-even. The minimum price at which the Cable division could sell is Eur 9,000 (equal to the Variable COGS, that would make the Contribution margin equal to 0). EXTERNAL PRODUCTION: Due to the cost structure of the department, characterized by Eur 9,000 of fixed costs, the external production would imply a loss for the Cable division equal to the aforementioned fixed costs.

d. Prysm Group
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GROUP OVERALL INTERAL PRODUCTION AT ACTUAL TRANSFER PRICING POLICY 35.000,00 3.600,00 - 16.000,00 22.600,00 7%

EXTERNAL PRODUCTION

MARKET-BASED
7.300,00 1.800,00 13.500,00 22.600,00 7%

COST PLUS 2%
2.035,20 360,00 20.204,80 22.600,00 7%

FULL COST
22.600,00 22.600,00 7%

VARIABLE COST
- 55.000,00 - 9.000,00 86.600,00 22.600,00 7%

FROM FLYING DUTCHMAN - 55.000,00 - 9.000,00 23.500,00 - 40.500,00 -12%

FROM CONTROL TECHNOLOGIES - 55.000,00 - 9.000,00 3.500,00 - 60.500,00 -18%

EBIT of System div. EBIT of Cable div. EBIT of Sub. div. (expect.) Goup EBIT (expected) Group ROS (expected)

INTERNAL PRODUCTION: On the basis of actual transfer pricing policies, the Group overall is expected to generate a return on sales of 7% with a EBIT of Eur 22,600. It would not be convenient for the Submarine division only. Of course, the different transfer pricing policies that we have hypothesized, would determine different EBITs among the three divisions. EXTERNAL PRODUCTION: Even if more convenient for the Submarine division, the externalization of the production is expected to determine a loss for the Group overall with both the suppliers, due to the weight of the fixed costs (Eur 64,000 in total) of the other two divisions.

Agenda
12

1.
2. 3. 4.

Problem identification
Framework of the alternatives Sourcing decision impact on the three divisions Solution

4. Solution
13

a.

Identification of the best transfer price

a.

Solution proposed to Mr. Zubini

a. Identification of the best transfer price

14

The actual TP method cannot be adopted, since the CP that finally sells to the outside customers would incur a loss and therefore would not accept at all the internal production. In order to avoid a loss for the Group overall, a better policy should therefore be adopted.

On the basis of the information available, a market-based transfer pricing would not be a good solution, because the cables market is not well-defined, affected by special pricing strategies and therefore it is not easy to predict what could be the market price to adopt.
Looking at cost-based methods, in order to motivate the Submarine division to encourage the internal production, the transfer price could be set equal to variable cost. The main issue of this policy is that without adding a lump-sum covering the supplying divisions related fixed costs, these would not get any advantage. With a full-cost method the Systems and Cables division would at least reach the break-even, but they would still make no margin and in case of limitation of the capacity they could not accept anymore to produce for the internal customer. Finally, a cost plus method would permit to all the divisions to have a positive return on sales and so

b. Solution proposed to Mr. Zubini

15

Following our analysis, we recommend to Prysm a cost plus-based transfer pricing method. This solution would permit the Submarine division to consider the internal production as a valid opportunity, being also competitive under a pure economical standpoint. The other two divisions would still have advantage, since not only they will offset their cost, but they will make a margin. We propose Mr. Zubini to give us more time and information in order to investigate about the proper percentage of mark-up to adopt for the Systems and Cables division. The amount should be determined by taking into consideration the market price of the products of the competitors, the standard mark-up charged by the competitors to their clients and standard mark-up charged by the two divisions when serving external customers. Eventually two different percentages of mark-up could be adopted for the two divisions. A delicate aspect to be taken into consideration is the available margin of capacity of the two divisions, in case of growth of their external demand or in case of growth of the demand of X73 cables.