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Pricing Environments and Transfer Price

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What are the two types of pricing environments for sales to external parties?

What is a transfer price? Why is determining a fair transfer price important to division managers?

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RESPONSE;

1. What are the two types of pricing environments for sales to external parties?

I have used different words in various search engines and found very few hits using the words "pricing environments." Is there another word that is used instead of environment?

a. One site referred to the internal and external pricing environment in a SWOT analysis - and the micro and macro environments. However, this is speaking more about marketing then pricing environment (http://www.marketingteacher.com/Lessons/lesson_marketing_environment.htm).

b. Exposure and economic environment - In another article on Hedging, it refers specifically to two pricing environments: exposure and economic environment in answer to the following question:

"Third, what are the various hedging instruments available to the corporate Treasurer and how do they behave in different pricing environments?

When is it best to use which instrument is the question the corporate Treasurer must answer. The difference between a mediocre corporate Treasury and an excellent one is their ability to operate within the context of their shareholder-delineated limits and choose the optimal hedging structure for a particular exposure and economic environment. Not every structure will work well in every environment. The corporate Treasury should be able to tailor the exposure using derivatives so that it fits the preferences and the view of the senior management and the board of directors. ...

Solution Summary

This solution identifies and explains the two types of pricing environments for sales to external parties. It then defines transfer price and explains the reason why determining a fair transfer price is important to division managers. This solution is 850 words.

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See Also This Related BrainMass Solution

Management Accounting: Mustra and Wilson, Limited

Question 1
For the past ten years Sam Ferny has been the general manager of Mustra, a division of Gemini Ltd which operates in Malaysia. Mustra manufactures computer circuit boards. Their strategy has been to achieve market share through flexible, Just-In-Time (JIT) production. Inventories are kept to a minimum and they maintain a highly trained workforce that operates at full capacity (this is achieved by adjusting their price to meet market demand, where necessary).

As new electronic devices are developed by other companies Mustra breaks-down and reverse-engineers the item in order to create a circuit board that will achieve the same functions. Mustra then markets these circuit boards to manufacturing companies which produce the cloned devices. A price premium can usually be charged for these circuit boards for about six months, after which the manufacturers are able to source their circuit boards from other production facilities and so Mustra either reduces their price or finds another new technology that they can mimic. Hence - flexibility and time-to-market are key to Mustra's strategy. Increasingly, quality (defined as the reliability of the product) is also important and Mustra has sought to achieve this by investing in xray equipment which allows the circuit boards to be examined for faulty soldering during the insertion process (the most common cause of product failure).

The operations at Mustra have suffered from significant levels of rework. This rework has been traced to the labour intensive insertion process. Sam is considering investing in a computer-controlled flexible manufacturing system (FMS). The reduction in rework is expected to lead to significant savings in the first year of operation, but even greater savings in subsequent years. Indeed, after a significant initial improvement, total costs for Mustra are expected to continue to be reduced by 10% each year through a program of continuous improvement made possible by the investment in the FMS. An improvement in revenue is also expected as the time-to-market is improved.

The management accountant has provided the following:
New FMS
Annual increase in revenue 60 000
Initial investment in equipment 820 000
Working capital (returned at the end of the project) 50 000
Annual depreciation 100 000
Salvage value at end of useful life 20 000
Useful life 8 years
Estimated cost savings in the first year of operation 50 000
Estimated cost savings in the second year of operation 100 000
Annual decrease in operating costs in years 2-8 10%
Weighted Average Cost of Capital (WACC) 12%
Tax rate for Mustra 30%

The WACC is used as the discount factor when evaluating new projects.

Performance evaluation throughout Gemini Ltd is based on Economic Value Added (EVA). Sam's performance has been declining over the past 3 years to the point that he is unlikely to get a bonus this year (the bonus makes up 30% of his potential remuneration).

HanKan Division is another profit centre of Gemini Ltd and is located in Hong Kong where the tax rate is 20%. Over the past 5 years Mustra has been supplying HanKan with circuit boards for production of a remote controlled car. Austral's variable cost of production for these boards is $8, and the shipping cost to Hong Kong is $0.20 per board. There are no direct fixed costs associated with the production of these circuit boards. HanKan could purchase the circuit boards from a local supplier for $10 each but company policy is that components be purchased internally, at variable cost.

1. Calculate the NPV, IRR, payback period (in years and months), and the accounting rate of return for the investment in the FMS. Comment on your analysis.
2. Explain to the Board of Directors why the investment in the FMS is in the best interests of the shareholders.
3. Comment on the effect that accepting the project will have on Sam's performance evaluation and bonus. Show, or refer to in the spreadsheet, any supporting calculations.
4. What changes would you make to Mustral's performance evaluation system to create incentives that will be consistent with their strategy (ignore the transfer pricing issue for now).
5. Consider the transfer-price for the circuit board used by HanKan. What target price will be in the best interests for Gemini Ltd? What are the implications for performance evaluation?

Question 2
Wilson Ltd makes computer monitors. Raw materials include a number of hazardous materials that are imported from China. When a monitor is identified as defective in the production process the hazardous materials can be extracted and re-used. Wilson has made a commitment to improving its environmental performance and has achieved the following results for 2007, 2008, 2009.

Table 2.1 Total Environmental Activity Costs
Environmental Activity 2007 2008 2009
Extracting hazardous materials from scrap I 200,000 400,000 650,000
Monitoring hazardous waste levels D 800,000 800,000 800,000
Auditing environmental activities D 300,000 400,000 500,000
Monitoring energy use D 320,000 640,000 830,000
Designing processes and products P 200,000 190,000 205,000
Processing recovered hazardous materials for reuse I 720,000 820,000 920,000
Training employees (environmental) P 100,000 120,000 235,000
Remediation (clean-up) E 2,100,000 1,200,000 660,000
Fines for exceeding pollution limits E 1,100,000 400,000 280,000

Table 2.2 Environmental Costs Categorised (you can assume that this categorisation is correct)

2007 2008 2009
Prevention (P) 300,000 310,000 440,000
Detection (D) 1,420,000 1,840,000 2,130,000
Internal Failure (I) 920,000 1,220,000 1,570,000
External Failure (F) 3,200,000 1,600,000 940,000
Total 5,840,000 4,970,000 5,080,000

Figure 2.1 Environmental costs per year

Breakdown of Environmental Costs by Classification for each Year

Figure 2.2 Environmental costs 2007
Figure 2.3 Environmental costs 2008
Figure 2.4 Environmental costs 2009

Wilson Ltd has performed activity analysis and identified cost drivers for a number of these environmental activities as follows:

Table 2.3 Environmental Activity Cost Drivers and Rates
Activity Cost Driver Activity Cost Rate
Extracting hazardous materials from scrap Tonnes extracted $3,000 per tonne
Designing processes and products Design Hours $2,000 per hour
Processing recovered hazardous materials for reuse Tonnes processed $1,500 per tonne
Training employees (environmental) Training Hours $1,800 per hour
Remediation (clean-up) Labour hours $15,000 per hour
Fines for exceeding pollution limits Number of fines Avg $12,000 per fine

Required:

1. Evaluate the changes in environmental performance, has the program been successful? Justify your response.
2. Briefly explain two ways in which the activity cost information could be used to improve environmental performance.
3. The manager of Wilson Ltd has heard of Lifecycle Assessment but is not sure how it relates to his business. Briefly explain to him the concept of lifecycle analysis and how he can influence the lifecycle environmental impact of his operations.
4. Make two recommendations to improve the environmental performance of Wilson Ltd.

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