PRESENTATION: PRICE AS A COST-PLUS STRATEGY AND ITS IMPLICATION. Tamás Vámosi, Associate Professor Copenhagen Business School
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1 PRESENTATION: PRICE AS A COST-PLUS STRATEGY AND ITS IMPLICATION Tamás Vámosi, Associate Professor Copenhagen Business School
2 Agenda: Challenges with a cost-plus pricing strategy regarding transfer prices and pricing implications in a Danish maritime company producing generators and power plants for ships. Difficulties in estimating costs exemplified by the cost-plus problem (Kaplan & Atkinson, 1998, p. 459). How to manage costs affecting pricing. 2
3 Transfer pricing (TP); criteria and methods Main criteria: The optimal transfer price for a product or service is its opportunity cost it is the value forgone by not using the transferred product in its next best alternative use. (Zimmerman, p. 178) But this criteria has to be balanced against (many) other criteria. The transfer price also has to be Congruent Controllable Manageable regarding to avoid manipulation/bias and Cost effective to produce The choice of a transfer pricing method in companies is important, because it does not merely reallocate total company profits among business units; it also affects the firm s total profits. (Zimmerman, p. 177) 3
4 From manufacturing to sales departments, from service departments (IT, HR ) to other departments 4
5 TP methods and their advantages and disadvantages Method Advantages Disadvantages Market-based transfer prices Objective (?!) Less subject to manipulation Often leads to correct long-run make/buy decisions Only exist for some products Might not capture interdependencies among divisions Variable-cost transfer prices Can approximate the opportunity cost of transferring one more unit Gives the buying division incentive to purchase the correct number of units if selling division has excess capacity Variable cost might vary with output Variable cost can be a poor approximation of opportunity cost Selling division has incentive to overuse variable cost Full-cost transfer prices Avoids disputes over which costs are fixed and which are variable Can approximate opportunity costs Selling division can export its inefficiencies to the buying division Death spiral Poor estimation of opportunity costs Imprecise calculations Negotiated transfer prices Both selling and buying divisions have incentives to transfer the number of units that maximize profits Time consuming Depends on the relative negotiating skills of the two divisions (power) Reorganize the buying and selling division Eliminates costly disputes over transfer pricing Reduces the benefits from having two decentralized responsibility centers 5
6 Power plant 6
7 In the following example the final cost is an outcome from the following four (TP) methods: 1. The total costs transferred from each division are marked up with 15% with no capital costs calculated 2. The mark-up is only calculated for the extra variable cost of 40 kr. which is added in each center. Each portion of 40 kr. is only marked-up once. 3. The mark-up is only calculated for the use of assets (100 kr. in each center). Each asset is only marked-up once. 4. Only variable costs are transferred - no mark-up calculated. 7
8 The cost-plus problem - inspired by a case company in the Danish Maritime Industry Division kr. (VO) Division 3 TP from division kr kr. TP from division kr. Division 4 Division 2 TP from division kr. Division 5 TP from division kr. Final cost Assumptions: 1. Cost of capital 15% 2. The 40 kr. is the extra variable costs incurred in each division. 3. Each division holds 100 kr. in assets 8
9 1. Total Cost plus 15%, no capital cost 100 kr. (VO) kr kr. TP = 140 kr. + 15% = 161 kr kr kr kr. TP = % = 231 TP = % = kr. TP = % = 405 Price? 9
10 2. Plus /mark-up is calculated only for the incremental cost in each division (40+15%). 100 kr. (VO) kr kr. TP = (40 kr. + 15%) = 146 kr kr kr kr. TP = (40+15%) = 192 TP = (40+ 15%) = 238 kr. 324 kr. TP = (40+ 15%) = 284 kr. Price? 10
11 3. Plus, VC + mark-up for assets (+ 15 kr) 100 kr. (VO) kr kr. TP = (100*15%) = 155 kr kr. TP = (100*15%) = 210 kr. TP = (100 * 15%) = kr kr. 360 kr. TP = (100 * 15%) = 320 Price? 11
12 4. Plus is not calculated, only VC 100 kr. (VO) kr kr. TP = = 140 kr kr. TP = kr. = 180 kr. TP = kr = 220 kr kr kr. 300 kr. TP = kr = 260 kr. Price? 12
13 Conclusions Criteria for good performance measures are important when analyzing transfer prices these has to be taken into consideration due to effects on costs/cm/profit. Often ignored! Final costs varies much (in the ex. between ) with huge impact on final price. Double (triple.) markup is a potential, dangerous trap. In case of 1) decentralized decision rights and 2) alternative, available market suppliers death spirals might occur. Costing practices and choice of transfer price method influence the allocation of intra organizational/divisional profit and (also) through this process final prices and firm profit. 13
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