INSTRUCTIONS TO THE CEO OF GOLIATH CORPORATION Congratulations! You have just be

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INSTRUCTIONS TO THE CEO OF GOLIATH CORPORATION

            Congratulations! You have just been appointed CEO of Goliath Corporation. One of the first items to cross your desk is the need for a review of transfer pricing policies. You have three divisions that report to you: Plastic Products, Metal Products, and Electronic Products. The manager in each of these divisions has considerable autonomy, and transactions between divisions are common. Division managers receive raises and bonuses in which divisional ROI and other accounting-based divisional earnings indicators play a major part. In keeping with maximum autonomy, you allow divisions to accept or reject any offer to buy or sell to another division. However, whenever an internal transaction does occur, the price must follow guidelines that you set. It is these guidelines that you are now considering.

            There are four possible mechanisms from which you can select. One is to use a market-based transfer price, with the divisions using actual competitive prices that the buyer would have to pay outsiders, less 2% to adjust for the economies of dealing internally (less sales effort, no bad debts, etc.). The second is a cost-based approach, with the selling division transferring its product at a price equal to its full manufacturing cost. The third is a negotiated transfer price which would be whatever price the two divisions can agree on. The fourth is a dual pricing mechanism, where the selling division receives 120% of its full manufacturing costs, and the buying division pays 98% of the market price they would otherwise pay outsiders.

            You must choose one of these policies and communicate it to your managers so that they can begin the process of operating their respective divisions. As CEO, you should feel free to observe some of their interactions to see how well your policy is working out. After setting the policy, however, you should not interfere with your managers’ autonomy. In other words, let them make their own decisions without pressure or guidance from you.

Your transfer pricing policy selection:

1. Market-based: policy is that the price the seller is receiving from its customers, less 2%.     

2. Cost-based: variable cost plus 25%.

3. Negotiated: whatever price the two parties can agree on.

4. Dual:

a) The selling division receives 110% of its full manufacturing costs.

b) The buying division pays 97% × (the market price they would pay outsiders).

INSTRUCTIONS TO THE MANAGER OF THE PLASTIC PRODUCTS DIVISION

                  Congratulations! You have just been appointed manager of the of Goliath Corporation Plastics Division.   Your annual bonus is an important part of your compensation and is tied to your total divisional income.   Your CEO currently is deciding on transfer pricing policy affecting your income, and will soon communicate this to you. In keeping with maximum autonomy, each division may enter transactions with outsiders or insiders as it sees fit. However, when an internal transaction occurs, the price must follow guidelines that headquarters sets. It is these guidelines that the CEO is now considering.

[SEE INSTRUCTIONS TO CEO ABOVE FOR THE DIFFERENT TRANSFER PRICING SELECTIONS]

OK! Now you are ready to negotiate with the other divisions.First, the Metals division wishes to purchase 5,000 equipment cases from you. Your cost/unit is as follows:

Currently, you have enough excess capacity in your plant to produce 5,000 more units per month. You now are selling 12,000 similar units/month to an outside customer, at $174 apiece, but you currently have no additional outside market. The Metals Division manager will be contacting you with an offer to purchase the units. Remember that you may accept or reject, and that the pricing will depend on the CEO’s new policy.

Second, you need 2000 electronic sensors, which you could purchase from a reliable outside source for $75 each. The Electronics Division is also a potential supplier, with the price based on the CEO’s new policy.

**Please note the results of your negotiations in the table at the very bottom page**

INSTRUCTIONS TO THE MANAGER OF THE METAL PRODUCTS DIVISION

Congratulations! You have just been appointed manager of the of Goliath Corporation Metals Division. Your annual bonus is an important part of your compensation and is tied to your total divisional income. Your CEO currently is deciding on transfer pricing policy affecting your income, and will soon communicate this to you. In keeping with maximum autonomy, each division may enter transactions with outsiders or insiders as it sees fit. However, when an internal transaction occurs, the price must follow guidelines that headquarters sets. It is these guidelines that the CEO is now considering.

[SEE INSTRUCTIONS TO CEO ABOVE FOR THE DIFFERENT TRANSFER PRICING SELECTIONS]

OK! Now you are ready to negotiate with the other divisions.

First, you need to purchase some equipment cases, either from the Plastics Division or from an outside source. You have a bid from a reliable outside supplier who will provide the 5,000 units/month that you need for $115 each. You also should consider buying them from the Plastics Division, with the price to be determined in accordance with your CEO’s new transfer price policy.

Second, the Electronics Division needs 8,000 brackets of an unusual design. Your costs to make and deliver these would be:

Currently you have enough excess capacity in your plant to produce 8,000 more units per month. You now are selling 21,000 units/month to an outside customer, at $104 apiece.

The Electronics Division manager will be contacting you with an offer to purchase 8,000 units. Remember that you may accept or reject the offer, and that the pricing will depend on the CEO’s new policy.

**Please note the results of your negotiations in the table at the very bottom page**

INSTRUCTIONS TO THE MANAGER OF THE ELECTRONICS DIVISION

Congratulations! You have just been appointed manager of the of Goliath Corporation Electronics Division. Your annual bonus is an important part of your compensation and is tied to your total divisional income. Your CEO currently is deciding on transfer pricing policy affecting your income, and will soon communicate this to you. In keeping with maximum autonomy, each division may enter transactions with outsiders or insiders as it sees fit. However, when an internal transaction occurs, the price must follow guidelines that headquarters sets. It is these guidelines that the CEO is now considering.

[SEE INSTRUCTIONS TO CEO ABOVE FOR THE DIFFERENT TRANSFER PRICING SELECTIONS]

OK! Now you are ready to negotiate with the other divisions.

First, you need to purchase some brackets of an unusual design, either from the Metals Division or from an outside source. You have a bid from a reliable outside supplier who will provide the 8,000 units/month that you need for $40 each. You also should consider buying them from the Metals Division, with the price to be determined in accordance with your new CEO’s transfer price policy.

Second, the Plastics Division needs 2,000 electronic sensors. Your costs to make and deliver these would be:

Currently you have no excess capacity in your plant to produce these units per month. You now are selling 11,000 similar units/month to outside customers, at $80 apiece.

The Plastics Division manager will be contacting you with an offer to purchase the units. Remember that you may accept or reject, and that the pricing will depend on the CEO’s new policy.

**Please note the results of your negotiations in the table at the very bottom page**

RESULTS:

Best for

Goliath?

Ceiling Price

&

Floor Price

Buyer

Buyer

#1

Plastics --> Metals

#2

Electronics --> Plastics

#3

Metals --> Electronics

Direct Materials $28.00 Direct Labor 17.00 Variable Overhead 34.00 Fixed Overhead 45.00 Total $124.00

Explanation / Answer

The table along with the reasons has been provided below:

Transaction Best for
Goliath? Ceiling Price
&
Floor Price Is transaction likely to occur? (i.e. Yes or No / Why) Market-based Cost-based Negotiated Dual Buyer Seller Buyer Seller Buyer Seller Buyer Seller #1
Plastics --> Metals Yes $115 Yes (98% of $115 is less than $115) Yes (98% of $115 – $79 = $33.70 Contribution) No ($115 is less than $124) Yes ($124 - $79 = $45 Contribution) Yes. (It is so because any price between the floor and ceiling will result in contribution to the seller with savings for the buyer. Yes (It is so because the amount paid of 98% of $115 is less than the outside price) Yes (120% of $124 – $79 = $69.80 Contribution) $79 #2
Electronics --> Plastics No $75 Yes (98% of $75 is less than $75) No (98% of $75 is less than $80) Yes ($68 is less than $75) No ($68 is less than $80) No. (It is so because it is not possible for the seller to match the outside prices and derive a contribution as the ceiling is below floor) Yes (It is so because the amount paid of 98% of 75 is less than the outside price) Yes (120% of $68 is greater than the price of $80 received from current customer) $80 #3
Metals --> Electronics No $40 Yes (98% of $40 is less than $40) No (98% of $40 is less than $49) No ($84 is less than $124) Yes ($84 is greater than $49) No. (It is so because it is not possible for the seller to match the outside prices and derive a contribution as the ceiling is below floor) Yes (It is so because the amount paid of 98%of $40 is less than the outside price) Yes (120% of $84 is greater than the outlay capacity of the division of $49. ) $49

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