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Transfer Price Problem

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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.

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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Greetings Inc. Swims in the Dot-com Sea: Transfer Pricing Issues

The attached file contains detailed information about my question.
Please read "the business situation", and then complete all of three questions.

Greetings Inc. Swims in the Dot-com Sea: Transfer Pricing Issues

The Business Situation

Two years ago, prior to a major capital-budgeting decision, Robert Burns, the president of Greetings Inc., faced a challenging transfer pricing issues. He knew that Greetings store managers had heard about the ABC study and that they knew a price increase for framed items would soon be on the way. In an effort to dissuade him from increasing the transfer price for framed prints, several store managers e-mailed him with detailed analyses showing how framed-print sales had given stores a strong competitive position and had increased revenues and profits. The store managers mentioned, however, that while they were opposed to an increase in the cost of framed prints, they were looking forward to a price decrease for unframed prints.
Management at WallDecor was very interested in changing the transfer pricing strategy. You had reported to them that setting the transfer price based on the product costs calculated by using traditional overhead allocation measures had been a major contributing factor to its non-optimal performance.
Here is a brief recap of what happened during presentation to Mr. Burns and the WallDEcor managers. Mr. Burns smiled during your presentation and graciously acknowledged your excellent activity-based costing (ABC) study and analysis. He even nodded with approval as you offered the following suggestions.
1. WallDecor should decrease the transfer price for high-volume, simple print items.
2. WallDecor should increase the transfer price for low-volume, complex framed print items.
3. Your analysis points to a transfer price that maintains the 20 percent markup over cost.
4. Adoption of these changes will provide WallDecor with an 11 percent return on investment (ROI), beating the required 10 percent expected by Greetings' board of directors.
5. Despite the objections of the store managers, the Greetings stores must accept the price changes.

Finishing your presentation, you asked the executive audience, "What questions do you have?" Mr. Burns responded as follows.

"Your analysis appears sound. However, it focuses almost exclusively on WallDecor. It appears to tell us little about how to move forward and benefit the entire company, especially the Greetings retail stores. Let me explain.
I am concerned about how individual store customers will react to the price changes, assuming the price increase of framed-print items is passed along to the customers. Store managers will welcome a decrease in the transfer price of unframed prints. They have complained about the high cost of prints from the beginning. With a decrease in print cost, store managers will be able to compete against mall stores for print items at a competitive selling price. In addition, the increase in store traffic for prints should increase the sales revenue for related items, such as cards, wrapping paper, and more. These are all low-margin items, but with increased sales volume of prints and related products, revenues and profits should grow for each store.
Furthermore, store managers will be upset with the increase in the cost of framed prints. Framed prints have generated substantial revenues and profits for the stores. Increasing the cost of framed prints to the stores could create one of three problems: First, a store manager may elect to keep the selling price of framed-print items the same. The results of this would be no change in revenues, but profits would decline because of the increase in cost of framed prints.
Second, a store manager may elect to increase the selling price of the framed prints to offset the cost increase. In this case, sales of framed prints would surely decline and so would revenues and profits. In addition, stores would likely see a decline in related sales of other expensive, high-quality, high-margin items. This is because sales data indicate that customers who purchase high-quality, high-price framed prints also purchase high-quality, high-margin items such as watches, jewelry, and cosmetics.
Third, a store manager may elect to search the outside market for framed prints."

Mr. Burns offered you the challenge of helping him bring change to the company's transfer prices so that both business units, Greetings stores and WallDecor, win. From his explanation, you could see and appreciate that setting the transfer price for unframed and framed prints impacts sale revenues and profits for related items and for the company overall. You immediately recognized the error in your presentation by simply providing a solution for WallDecor alone.
You drove home that night thinking about the challenge. You recognized the need and importance of anticipating the reaction of Greetings store customers to changes in the prices of unframed and framed prints. The next day, the marketing team provided you with the following average data.

 For every unframed print sold (assume one print per customer), that customer purchases related products resulting in $4 of additional profit.
 For every framed print sold (assume one print per customer), that customer purchases related products resulting in $8 of additional profit.
 Each Greetings store sets its own selling price for unframed and framed prints. Store managers need this type of flexibility to be responsive to competitive pressures. On average the pricing for stores is as follows: unframed prints $21, steel-framed without matting $50, wood-framed with matting $70.


Answer each of the following questions.

1. Prepare for class discussion what you think were the critical challenges for Mr. Burns. Recognize that WallDecor is a profit center and each Greetings store is a profit center.
2. After lengthy and sometimes heated negotiations between WallDecor and the store managers, a new transfer price was determined that calls for the stores and WallDecor to split the profits on unframed prints 30/70 (30% to the store, 70% to WallDecor) and the profits on framed prints 50/50. The following additional terms were also agreed to:
 "Profits" are defined as the store selling price less the ABC cost.
 Stores do not share the profits from related products with WallDecor.
 WallDecor will not seek to sell unframed and framed print items through anyone other than Greetings.
 WallDecor will work to decrease costs.
 Greetings stores will not seek suppliers of prints other than WallDecor.
 Stores will keep the selling price of framed prints as it was before the change in transfer price. On average, stores will decrease the selling price of unframed prints to $20, with an expected increase in volume to 100,000 prints.

Analyze how WallDecor and the stores benefited from this new agreement. In your analysis, first (a) compute the profits of the stores and WallDecor using traditional amounts related to pricing, cost, and a 20% mark-up on WallDecor costs. Next, (b) compute the profits of the stores and WallDecor using the ABC cost and negotiated transfer price approach. Finally, (c) explain your findings, linking the overall profits for stores and WallDecor.
The following data apply to this analysis. (Round all calculations to three decimal places.)

print Steel-framed,
no matting Wood-framed,
with matting
Average selling price by stores before
Transfer pricing study $21 $50 $70
Average selling price by stores after
Transfer pricing study $20 $50 $70
Volume at traditional selling price 80,000 15,000 7,000
Volume at new selling price 100,000 15,000 7,000
WallDecor cost (traditional) $17.36 $33.48 $48.10
ABC cost $15.258 $39.028 $55.328

3. Review the additional terms of the agreement listed in instruction 2, above. In each case, state whether the item is appropriate, unnecessary, ineffective, or potentially harmful to the overall company.

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