Transfer price is the price which the company divisions handle with each other. The plan is the sale of one division is the purchase of another division. Transfer pricing will therefore arise when divisions are having transactions with each other. Also, for the buying division, the transfer price is the variable cost to them.
The transfer price signifies a basis of revenue to the Selling Division, and a cost to the Buying Division. Decisions taken by a divisional manager might be for his own interests but in contrast to the interests of another division and the organisation as a whole. It is often that the divisional manager considers the profitability of its own division rather than corporate profit maximisation. Goal analogy is not easy to achieve.
The transfer price set by selling division could mainly progress its profit but only little profit is produced by the buying division if the transfer price is based on market values and in contrast towering profits are recorded if transfer price is based on recovering costs and a fraction of profit of the selling division. In such situations it is not fair to relate the profits of these two divisions as profit potential is transferred from the one division to the other. The process and basis of setting a transfer price is therefore essential for an accurate divisional performance measure.
The basis of setting transfer price contains using variable cost, full cost, cost plus, market value, profit potential and market dynamics. Setting the transfer price based solely on cost will distort the performance of the selling division (in our case division A) to the benefit of the performace of the buying division (in our case division B). It is therefore appreciated that transfer price based on cost alone is not appropriate as a divisional performance measure.
(c)
The transfer price range of the divisions has to be set in order to be competitive to the open market conditions and taking into account the market dynamics. For division A the transfer price range is set between 66 that is very low and has caused the division A manager complains to the optimum 90 that corresponds to the market price, however it carries the uncertainty of managing to sell all production of 400.000 units.
Taking the market figures and transferring Division A to Division B, as at 31st of March 20X3, the contribution margin is set too high for Division A, in difference from Division B which is set too low. For Division A instead of £5 million rises to £15.2 million and for Division B instead of £19 million decreases to £9.6 million.
Both Division managers considering the above have to make a deal on the transfer price that will result to a win-win result with regard to how the profits are fairly separated between each division. They may decide not to go through with the transfer, but if they do, they must be prepared to face market conditions that may culminate to fewer sales for division A and higher costs for division B.
There are two things to consider: (1) the selling division will agree to transfer only if the profits of the selling division rise as a result of the transfer, and (2) the buying division will agree to the transfer and absorb all production only if the cost is well below market price and thus income of the buying division also increase as a result of the transfer. This may seem clear, but it is an important point.
Both managers have good negotiating arguments as division A has broad range to improve performance and division B holds the key to division's A guaranteed sales. In order to reach a mutual acceptable decision then; division A must be prepared to sell below market value and division B to buy above the 110% cost of A and below market value.
Considering the contribution margin of the firm as a whole and adding it to the variable costs of each division would consitute a valid basis for the negotiation. The latter is called the Minimum Transfer Price = Incremental cost (variable costs) + Opportunity cost (Contribution margin of the firm).
Applying the principle to the current situation the firm's contribution margin ratio is, 150-(52+36) / 150 = 0.41. Thus the tranfer pricing would be 52*1.41=73 and the corresponding contribution margins will be:
Division A - (73-52) * 400.000 = 8.400.000 and
Division B - (150-(36+73)) * 400.000 = 16.400.000
(d)
Furthermore, both Divisions could use three types of transfer prices for benefit overall operation. First one transfer price is the cost based price which the transfer price may be based on variable cost on its own or on variable cost plus fixed costs. Companies may increase on a mark-up to the numbers. These costs may be actual, budgeted or full cost. Cost based approach often leads to reduced performance evaluations and distorted purchasing decisions, although it's still widely used for its simplicity.
On the other hand, market based transfer price is based on current competing market prices and services. Companies using market based transfer pricing maybe on a bad faith with situations of suffering prices. To overcome this, they essentially need to price their transfer at an adjusted market price as would be suitable to measure the divisional performance. A market based system is often considered the best approach because it is objective and mostly provides the proper economic incentives.
When negotiated transfer prices are used in the company, the managers who are involved in proposed transfer inside the company come across to discuss the terms and conditions of the transfer. Negotiated transfer prices have many significant advantages.The managers of the divisions are possibly to have much better information about the potential costs and welfares of the transfer than others in the company.Obviously, if the transfer price is lower than the selling division's cost, a loss will arise on the deal and the selling division will refuse to agree to the transfer, whilst on the other hand, if the transfer price is set too high, it will be impossible for the buying division to make any profit on the moved item. By taking in consideration these types of transfer pricing the best way of both divisions in order to make a deal is the negotiated transfer price which is the fairest approach and can elicit desirable management behaviour at Midland and thus benefit overall operations.
Part B
(b)
Residual income is a division performance measure; it would reflect earnings available to owners. This part of income can be calculated as division exact profit minus minimum expected earnings. In general, the higher residual income take place the more wealth business is creating.
On the contrary, negative or less residual income could means that company is consuming capital. There are four main strengths of residual income measure. First, terminal values do not make up a large portion of total present value, relative to other models.
Second, it uses readily available accounting data. Third, it can be used for companies that do not pay dividends. Moreover, it is more flexible and focuses on economic profitability. (PME, 2009).
On the other hand, there are also several weaknesses of residual income measure. It is based on accounting data and significant adjustments may be needed. It is useless when book value is not predictable and it is not suitable for the comparison between different departments, because large department and small department will be different.
Return on investment is a performance measure which used to evaluate the value of investment and can compare the value of a number of different investments. This kind of performance measure can be calculated through profit divide investment. It is important because return on investment reflects the purpose of company how much profit they are expected to get through their investment.
Profit and investment are linked in the business, manager want to get higher return therefore they need to consider how much asset they have and how much they are willing to invest. Return on investment is simply to calculate, and reflect the ability of gain profit of the project. Higher return on investment could be a good indicator to attract the investors, and vice versa.
However, return on investment does not consider the factor of time value of money. (Sam, 2012) It cannot exact reflect the influence of time which used in the project. If building the project last a long time, there will be other intangible factors may affect the project value. For example, interest of bank loan. Some project need huge amount of investment to put in such as property.
Developers would need borrow money from banks, the more money developer borrowed the more interest they have to pay back to bank. Besides, they also have to pay more if the project last long time. Such intangible factors will not show in the return of investment.
Net present value is the difference between the present value of future cash inflows from an investment and the amount of investment. When net present value is positive, it means the project would get more profit than investors expected. When the net present value is negative, the project would possible have loss.
Therefore, do not invest the project if its net present value is negative. When the net present value equals zero, it means the project would have profit which they are expected. There are three main strengths of net present value evaluation.
First, it considers the facts of time value of money. Improve the evaluation of investment economical efficiency. Second, it considers the whole process of net cash flow, which reflects the unity of liquidity and profitability. Third, net present value considers the investment risk, if the risk is high, then the use of the high discount rate. If the risk is low, then the use of the low discount rate.
Nevertheless, net present value is complex to calculate compared with residual income and return on investment, it is difficult to know well. The calculation is very sensitive with the discount rate, any small change in discount rate will leads large change in the net present value. Second, net cash flow measurement and the discount rate is also difficult to determine. It is usually relies on uncertain forecasts of future cash flows. Therefore, it is difficult to judge the project good or bad because of uncertain factors. Monte-Carlo simulation is the best solution to deal with these problems is to calculate a range of net present value numbers by using different discount rate and forecast, so it can generate normal, best and worst net present value numbers. It is a useful approach for financial modeling which uses random inputs to model uncertainty. (Moneyterms, 2005)
There are also other approaches could avoid dysfunctional behavior which is motivated by accounting-based performance targets. For example, do not place too much emphasis on short-term performance measures and place greater emphasis on the long term by adopting a profit-conscious style of evaluation. Focus on controllable residual income or economic value added combined with asset valuations derived from depreciation models that are consistent with net present value calculations.
Alternatively, performance evaluation might be based on a comparison of budgeted and actual cash flows. The budgeted cash flows should be based on cash flows that are used to appraise capital investments.
Part C
A decision tree provides support when it comes to a decision by showing potential outcomes of different procedures. It is used for the maner of researching in order to find the best option with the best outcome. Moreover, by the use of decision tree the user understands the risks and rewards of each option and decides which one is the best. Useful ideas can draw conclusions, even with very little evidence. Can also be joint with other techniques such NPV decision. On the other hand, the downside to a decision tree is that is limited to one output attribute. Further, the data may be pushed under certain conditions concluding that the data is unproductive.
Expected Value is the likely outcome of the option taken by companies and is giving the opportunity for investors to choose the most likely choice that will give the company the desirable outcome. The calculation of finding expected value is by multiplying all of the likely outcomes each, by the possibility that will take place with each outcome and summing them all. In contrast, expected value has the drawback of not having guarantee whether the actual outcome will be the same with the expected value result.
Maximin criterion is that the worst potential outcome will always take place and the firm or the decision maker has to choose the major payoff. The maximin criterion is a process that assures that the decision maker can accomplish the top of the poorest outcomes. In order to achieve that, maximin criterion focuses on staring the worst outcome that could occur and eventually helping the decision maker to take the option that could gain the biggest return. On the other hand, maximin criterion is an enormously traditional decision criterion and may lead to some bad decisions.
Maximax criterion is the opposite of maximin criterion and is focus on achieving the best of the best outcomes under each action. The business or decision maker has to choose the action that could give the largest value. In addition, maximax criterion drawback is that is a risky approach because the decision maker ignores the probabilities and focuses on the large payoffs.
Regret criterion states that if the chosen alternative is not the best result, then it is the opportunity loss for decision maker. In a condition in which a choice has been made that causes the normal payoff of an event to be not as much of than expected, this criterion support the avoidance of regret. Regret is calculated as the difference between the best and worst likely payoff for each selection. Regret criterion is better decision making tool than Maximax and Maximin. This is due to the fact that it contains more problem information, thus a more knowledgeable result can be made.
