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Transfer Price Problem

Case 5-2 IBM Data Center for Eastman Kodiak

In 1989, IBM and Kodak entered into and agreement whereby IBM would build and operate a data processing center in Rochester, NY that consolidates five Kodak data centers into one. Of the five original data centers, three were at separate sites in Rochester, one was in Colorado, and the fifth was in Canada. Over 300 Kodak data processing employees became IBM employees. Original Kodak-owned IBM computer equipment was purchased by IBM and moved in the IBM data center. IBM augmented this equipment with a significant amount of new equipment (both IBM and non-IBM products).
Kodak pays an annual fee to IBM based on the amount of computing services it receives (lines printed, amount of disk space, etc.) The IBM data center pays all labor costs, occupancy costs, and the costs of all software and hardware acquired. The IBM data center is evaluated based on profits and the satisfaction of Kodak customers.
Prior to the IBM-Kodak agreement, excess capacity in the mainframe business increased price competition. A third party vendor made a bid to operate Kodak's five data centers at a substantial cost savings to Kodak. One source of the savings came from the vendor using less expensive computers that are plug-compatible with IBM's machines. IBM made a successful counteroffer to keep the Kodak account and run the data center.
Kodak views this contract as very important because it allows it to get out of the business of operating computers and focus management's attention on more strategic issues, such as the design and maintenance of applications software directed at Kodak's core business. These application computer programs run at the data center and include billing, payroll, accounts payable and receivable, cost accounting, and manufacturing production control and scheduling.
IBM considers the data center an important test case for its other large corporate clients looking o move away from IBM hardware to cheaper plug-compatible mainframe clones. If IBM can successfully operate this data center for Kodak, it opens an important market of other Fortune 100 companies. IBM has the expertise in centralizing and standardizing different data centers into one using a common set of operating standards. There are economics of scale in corporate computing. Also, operating data centers allow IBM to learn about large corporate clients computing, develop new software and hardware, and test new products before they are released.
One key issue that arises is the internal transfer price the IBM data center pays for the IBM hardware and software it "purchases" from other IBM divisions. This transfer price does not affect the price Kodak pays to IBM. Suppose a hypothetical IBM mainframe numbered A606 that sells for $3 million is installed in unit manufactured cost (UMC), including fixed and variable costs, is $1.6 million. Moreover, IBM's total selling, general, and administrative (SG&A) costs are 30 percent of revenue, of which half (15 percent) varies directly with revenues. The plug-compatible machine comparable to the A606 sells for $1.9 million. The other IBM divisions providing goods and services to the data center have profit responsibilities.

Required:
A: What factors should IBM consider when developing the transfer pricing rule used to charge the data center for IBM products installed in the data center?

B: Given the limited information in the case, what transfer price rule would you suggest IBM adopt for IBM products installed in the data center?

C: Using your transfer price rule, what price should be charged for the hypothetical A606 mainframe?

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Solution contains answer of a transfer price problem.

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