Transfer Pricing at Southern
1. Cost Based Transfer Price
Maintain the status quo within the company. All cost methods require
that standard costs be used; therefore each division is encouraged to
meet standard cost levels, instead of working around actual costs.
This will increase goal congruence.
Currently, the price Southern is charging is based on the market but
they are running under capacity and had excess inventory. Therefore,
Thompson is charging market price even though he is running under
capacity. If Southern’s VC = 60% then the 40% represents OH and
To prevent conflicts in the future it must be clear that variable
costs of one division are not actually ...view middle of the document...
Increase communication between divisions. Currently, Northern may not
know that Thompson is paying a higher then expected price for the
intermediate materials they need from Southern. If Northern was aware
of the amount of upstream costs and profit involved internally, it
might be encouraged to forgo its own profits for the sake of the
company as a whole. Profit sharing could be introduced to motivate
Northern to do this.
A specified set of rules would be set up when each manager is
negotiating a price. Such as if there is a match in price internally
and externally, the business must be kept internally. Also if the
managers cannot come to an agreement on price the outside market price
will be used.
If true negotiation occurred at Birch, each division manager would
have full information on markets and costs. The two divisions could
negotiate a lower price for the raw material so that both units would
make a contribution to their profit.
Advantages: Thompson would be free to charge a profit on any design
work the division does. This process would open the lines of
communication between divisions. This would be worth it to Birch since
there are many transactions between Thompson and Southern.
Disadvantages: If they don’t come to an agreement they are back where
they began. It may not be worth it expend these kind of resources if
there are very few transactions.
Agreement among Business Units (Needed?)
Set up a mechanism for the divisions to agree on outside selling
prices and for profit sharing when there is significant upstream FC
Advantage: this would solve the lack of communication and allocate
upstream costs and profits.
Disadvantage: it may not be worth their time and resources.
3. Market Price
Six conditions must exist that make this alternative feasible.
Since top management has implemented a profit center structure the
company has improved its market position. It can be assumed then that
the divisional mangers have both short-run and long-run interests in
mind and therefore, are competent.
Currently there are communication problems between divisions that if
solved, will provide a good atmosphere. If a fair transfer price
method is employed, goal congruence will increase as these managers
will be motivated to meet both their divisional interests and the
interest of the overall company.
A Market Price
Thompson primarily sells to outside customers; therefore, once the
higher markup is omitted, his price would be close to competitive.
Thompson should have included a profit amount when doing the design
work for Northern. Conversely, Thompson’s sources are constrained,
there isn’t a market for the intermediate products they need. Once
the vice president has analysed the cost structures, each division
will be more likely to offer a closer approximation to market price
Freedom to source
As mentioned in the case, each division is encouraged to either buy...