Page 109 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes 5.2.2 Alternatives to Market Prices

Sometimes market prices are unavailable, inappropriate or too costly to be used for transfer
pricing.
Full cost basis: If the transfers are based on actual costs, the performance of the receiving
decisions will bear the accumulated efficiencies or inefficiencies of other divisions subject to
their control. Therefore, some version of standard pre-budgeted costs is better than actual costs
because it gives incentive to control cost but that also will lead to suboptimal decisions and goal
incongruence.

Cost plus as a synthetic market price: Since, the transferred product or service in question is
often slightly different in quality or other characteristics from that available from outside
sources, cost plus pricing is considered “satisfactory” as an approximation of an outside market
price. The alternative getting ‘real’ market prices - is perceived as being too costly for incorporating
into a routine control system.
Variable cost plus lump sum: Top management often wants the buyer - division manager to
make month-to-month purchasing decisions based on the variable costs of the supplier division.
A separate predetermined lump sum charge is made for fixed costs plus a lump sum profit; this
charge may be made annually or monthly. It is based on an annual expectation of quantity, not
on actual purchases. This is also known as two-step pricing.

Example: The following information is given:
Business Unit X (manufacturer) Product A
Expected monthly sales to business unit Y 500 units

Variable cost per unit ` 5/-
Monthly fixed costs assigned to product ` 20,000/-
Investment in working capital & facilities 1200,000
Competitive return on investment per year 10%

One way to transfer product A to business unit Y is at a price per unit, calculated as follows:
Transfer price for Prod A
Variable cost per unit ` 5/-
Plus fixed cost per unit ` 4/-

Plus profit per unit ` 2/-
Transfer price per unit ` 11/-

10% of monthly investment percent  = ` 2

The system works as under: The transfer price of ` 11 per unit is a variable cost so far as unit Y is
concerned. However, the company’s variable cost for product A is ` 5/- per unit. Thus, unit Y
does not have the full information to make appropriate short-term marketing decisions. i.e., if
unit Y knew the company’s variable costs.

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