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CoursHeroTranscribedText: 'BBR prides itself on being a growing, prosperous company, its success being partly due to a good management team which fully participates in its development via a decentralized control system. This statement was questioned at the meeting which took place between John North, group finance director of BBR and Paul Giddings, divisional general manager of the Shrewsbury plant. The surprise came when Paul revealed that he did not believe he was responsible for his division's profitability. This, he claimed, was due to the company's transfer-pricing policy. Historically, Paul's division bought over 50% of its total input of rubber hose from a sister division located in Preston. This trade annually accounted for about 25-35% of the Preston division's total output. Paul felt that the transfer price was unfair, and hence his division's reported profit was not a true reflection of his operational effectiveness. In the ensuing conversation both men agreed in principle that divisional general managers are delegated discretionary control over short-term strategy development, day-to-day operating decisions and capital expenditure decisions up to a prescribed limit. However, Paul claimed that in practice other factors intervened to reduce the divisional manager's degree of control and took, as an example, the inter-divisional trade in rubber hose. The rubber hose trade Fundamentally, the Preston division produces rubber hose which is then sold to, among others, Paul's Shrewsbury division where it is 'tailored' for hydraulic uses in pit props, aircraft undercarriages and heavy plant and equipment. Before the annual budgets are compiled, the divisional general managers enter into negotiations about fixing the transfer price. Three months' notice is required before any mutually agreed price can be revised. The managers themselves spend one or two days negotiating the transfer price for the forthcoming months. At this meeting, information provided by their respective management accountants and annual cost variances provided by the central purchasing officer of BBR are available. The Preston division provides cost data relating to standard variable and fixed coststraceable to the division, plus an apportiomnent for selling, administrative and distribution costs. Normally, these data provide a platform price for the negotiations. The forecasts given by the central purchasing officer are included in these cost estimates. The Preston subsidiary is unaware of the assumptions on which the purchasing forecasts are based, but nevertheless accepts them as relevant to the fixing of the transfer price. The Shrewsbury division also compiles standard cost data, and in addition presents price list information with the likely allowable discounts it can hope to receive 'orn alternative suppliers. On some oecasiom these latter estimates form the ceiling price for the negotiations on the transfer price. One of the difficulties that has been experienced is that the range between the cost estimates at Preston and the competitor list prices at Shrewsbury can be vast. So much so that the platform price exceeds the ceiling price. This may occur when excess supply is expected to characterize the external market. Hard-nosed negotiations can result in the ultimate tramfer price being less than satisfactory to both parties and there is always the possibility for unrelated disputes to interfere with the unstructured negotiatiom on the transfer price. IWhen a transfer price has been negotiated, this is incorporated in the annual budgets of the divisions resulting in separate prot targets. The Preston division requires large volume production in order to obtain economies of scale and to maintain its competitive position in the external market. Manufacturing set-up costs are high, and hence there are real cost savings in having long production runs. The Sluewsbury division, on the other hand, is committed to increasing its share of the fma] product market which is price-sensitive. The end-users are mainly multinational companies and have access to world-wide suppliers. The differing orientations are perhaps best illustrated by the rmponses to a question put to the respective divisional managers about the degree of autonomy which they exercise. Does the authority to use external markets freely, to develop and innovate products, and to plan the division's future: Preston Shrewsbury Division Division (a) Reduce the interdependence between the companies Agree Disagree of the group? (b) Make compliance with corporate plans more difficult? Agree Disagree (c) Allow your division's performance to be a more Agree Agree realistic reflection of your worth or effort? (d) Motivate you to use more your ingenuity, Agree Agree imagination, and creativity? (e) Cause corporate/group objectives to give ground to Agree Disagree division's goals? (f) Enhance the competitive effectiveness of the group as Disagree Agree a whole? Paul Giddings feels that at the transfer-price negotiating stage, he is always in a weak position. There are only two other domestic suppliers and three overseas who could supply the rubber hose in the volume he requires. Even then it is unlikely that any one of these five external suppliers would be willing to handle more than 20% of his division's total needs. His input to the negotiations is based on volume discounts likely to be available from the external suppliers and he argues that the Preston division should give a substantially better discount when he is buying internally because Preston avoids the problems of the settlement and payments, advertising and some transportation costs. In fact, he argues that the economies of scale Preston enjoys from the internal trade are being passed on in disproportionately lower prices to potential competitors of the Shrewsbury division. The Preston division counters that the savings obtained by the large volume of internal sales enables it to be cost-efficient and innovative in developing new production techniques.Exhibit 401.1 provides cost data which the managers are using in their current negotiations. The transfer price proposed by the Preston division is f12.50 per meter of rubber hose. Exhibit 401.1 Cost data available for the transfer pricing negotiations Preston Division Output Average Average (OOD metres material cost direct Labour of rubber hose} [E per metre) cost (E per metre) 100 5,00 5:00 200 7.70 4.80 300 7.50 4.70 400 7.20 450 500 7,00 4.10 600 6.50 4 00 700 6.00 3.80 800 5.50 3.60 5.00 3.40 1000 4.50 3.20 Annual budgeted divisional fixed costs E160 000 Annual budgeted allocation of selling administration and E40 000 transportation costs Proposed transfer price E12.50 per metre Shrewsbury Division Buy-in order size Average external Average (000 metres of suppliers list price discount rubber hose) ([ per metre) (% per metre) 100 14 nil 200 14 3.57 300 14 7:15 400 14 11.6 500 14 15.0

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