Transfer pricing issue that is common in decentralized, divisionalized firms

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TEACHING NOTE GENTABS (API)

PURPOSE

This study describes and discusses a transfer pricing issue that is common in decentralized, divisionalized firms. The case raises issues about internal pricing and, more generally, the operation of a decentralized management structure. The case emphasizes on the issues of behavioral implications of performance measurement system and incentives. It also covers budgeting process, responsibility accounting and absorption of overheads.

DESIGN/METHODOLOGY/APPROACH

The discussion of the situation in the case draws on budgeting process and internal conflicts between the managers on pricing issues in decentralized environment where individual performance is measured through divisional performance. Data is collected by using both primary as well as secondary sources.

FINDINGS

To identify the issues associated with responsibility accounting and performance measurement systems among the divisions and to describe the difficulty in synchronizing the organizational goals with individual's goal.

Originality/value

This study provides historical context from an Indian Pharma company. It reveals the difficulty in alignement of oraganisations goals with individual's goals where the incentives are set according to the department's performance. In such situations, organizational goals are compromised. Thus, it highlights the pitfalls in performance measurement systems in decentralized organizations and the role of top management in resolving these issues.

Suggested Assignment Questions:

1) What should Mr. SK do? Should he outsource the products or buy it from manufacturing division?

2) Identify the products which should be bought from the manufacturing division and which can be outsourced under different pricing policies.

3) Which decision is more beneficial for: a) Global API, b) Gentabs c) Both?

4) How can the dispute be resolved? How can the mangers be motivated to work towards achievement of organizational goals?

5) Should the top management interfere?

Case Analysis

The suggested assignment points students in the right direction.

1) What should Mr. SK do? Should he outsource the products or buy it from manufacturing division?

The issue in the case arises because the manager of Global API complained about not getting the suitable budgeted transfer prices to achieve his growth targets of contribution and net income next year. His arguments are the following:

a) The transfer prices have changed to full cost from variable cost basis. The main business of the company is dosage (tablets) business as is evident from the given facts. The demands of dosage are fulfilled first and the balance is available for Global API. The plant is working at its normal capacity. There is no intention of increasing the capacity for producing molecules for Global API. That is why, loading of fixed costs to Global API are not justified.

b) It is mentioned in the case that even when the transfer prices were charged at variable cost plus mark up the prices were masking the full cost. Therefore, fixed costs even if the fixed costs are found to be relevant, these were already taken into account.

c) Mr. SK is also worried about the expected increase in variable costs by 7%.Global API contribution in 2009 is about 20% which is quite good. But if variable costs increase next year, contribution margins will go down. Therefore, his performance bonus will also be affected.

d) Students in the light of above facts may answer that the molecules should be sourced from outside.

2) Identify the products which should be bought from the manufacturing division and which can be outsourced.

For the second question students should be asked to do the mathematical calculations using variable cost and full cost approach.

Variable Cost Approach:

Exhibit 1: Data given in the Case (Amount in US $)

Name of the molecule

Estimated Sales of API ( in tons)

Selling price per ton

Variable cost per ton

Fixed cost per ton

Sourcing cost

Plant capacity ( tons pa)

Dosage requirements (tons pa)

Simvastatin

10

500

465

125

350

20

12

Cefaclor

36

250

260

25

205

46

20

Clarithromycin

40

4500

4000

1250

4250

60

25

Cilazapril

0.5

16000

17500

2500

15000

1

0.2

Midazolam

0.7

4500

4000

1250

4250

1

0.1

Ketorolac

15

13000

13000

1500

18000

20

12

Exhibit: 2 Contributions from Molecules (Amount in US $)

Name of the molecule

Selling price

Variable costs

Reduction in Conversion costs

Contribution

Revised contribution

Simvastatin

500

465

-165

35

200

Cefaclor

250

260

-25

-10

15

Clarithromycin

4500

4000

-265

500

765

Cilazapril

16000

17500

-135

-1500

-1365

Midazolam

4500

4000

-265

500

765

Ketorolac

13000

13000

-1300

0

1300

The figures in Exhibit 2 show that the contribution without revision of conversion costs is negative in case of two molecules - Cefaclor and Cilazapril. But when the costs are revised after negotiations and reconsidering the conversion costs the contribution became positive and good for all molecules except Cilazapril. Thus, Mr. SK should buy from manufacturing division if the transfer prices are based on variable costs as the contribution is positive. In the case of negative contribution he can outsource the molecules.

If Mr. SK outsources the molecules for improving the contribution of his own department the manufacturing department may suffer on account of unabsorbed overheads.

Exhibit 3: Unabsorbed Overheads (Amount in US $)

Name of the molecule

Estimated sale volumes of API business pa

Dosage requirements ( TPA)

Plant capacity ( tons pa)

Deficit capacity if not sourced

Excess capacity if sourced

Fixed Costs

Unabsorbed fixed costs if sourced

Simvastatin

10

12

20

-2

8

125

50

Cefaclor

36

20

46

-10

26

25

14

Clarithromycin

40

25

60

-5

35

1250

729

Cilazapril

0.5

0.2

1

0.3

0.8

2500

2000

Midazolam

0.7

0.1

1

0.2

0.9

1250

1125

Ketorolac

15

12

20

-7

8

1500

600

From Exhibit 3, it is clear that there is deficit of capacity (after selling to the dosage division) in all the molecules except Cilazapril and Midazolam. To avoid negative contribution of Cilazapril , if Mr. SK outsources Cilazapril to get a positive contribution of US$1000 there would be unabsorbed fixed overheads of US $2000 for manufacturing department. Manufacturing department's performance is evaluated on the basis of absorption of fixed costs as it is a cost centre. Thus, one department would benefit at the cost of another department and Gentabs as a whole would stand to lose as contribution is lesser than the unabsorbed overheads. In case of Midazolam, since the contribution is positive and there is excess capacity Mr. SK can easily buy it from manufacturing division.

Full Cost Approach:

If the molecules are transferred on full cost basis then the net profit for Global API will be as follows:

Exhibit: 4: Net profit (Amount in US $)

Name of the molecule

Selling price

Variable costs

Fixed Costs

Reduction in Conversion costs

Revised full cost

Net Profit

Simvastatin

500

465

125

-165

425

75

Cefaclor

250

260

25

-25

260

-10

Clarithromycin

4500

4000

1250

-265

4985

-485

Cilazapril

16000

17500

2500

-135

19865

-3865

Midazolam

4500

4000

1250

-265

4985

-485

Ketorolac

13000

13000

1500

-1300

13200

-200

Thus, under full cost apporoach, API division would want to outsource all other molecules except simvastatin as it will make losses on them. This will lead to unabsorbed fixed overheads for manufacturing department and the net profit from molecules for Gentabs as a whole would be as follows:

Exhibit 5: Comparison of outsourcing with unabsorbed fixed costs

(Amount in US $)

Name of the Molecule

Selling price

Sourcing costs

Unabsorbed fixed costs if sourced

Net Profit for Gentabs

Contribution for API if outsourced

Simvastatin

500

350

50

100.00

150

Cefaclor

250

205

14.13

30.87

45

Clarithromycin

4500

4250

729.17

-479.17

250

Cilazapril

16000

15000

2000.00

-1000.00

1000

Midazolam

4500

4250

1125.00

-875.00

250

Ketorolac

13000

18000

600.00

-5600.00

-5000

Thus, for company as a whole it not beneficial to outsource Clarithromycin, Midazolam and Ketorolac. While, it would be indifferent to buy or outsource Cilazapril.

3) Which decision is more beneficial for: a) Global API, b) Gentabs c) Both?

Under Variable Cost Approach

Name of the Molecule

Gentabs

API

Simvastatin

Buy from manufacturing

Buy from manufacturing

Cefaclor

Buy from manufacturing

Buy from manufacturing

Clarithromycin

Buy from manufacturing

Buy from manufacturing

Cilazapril

Buy from manufacturing

Outsource

Midazolam

Buy from manufacturing

Buy from manufacturing

Ketorolac

Buy from manufacturing

Buy from manufacturing

Under Full Cost Approach

Name of the molecule

Gentabs

API

Simvastatin

Outsource

Outsource

Cefaclor

Outsource

Outsource

Clarithromycin

Buy from manufacturing

Outsource

Cilazapril

Indifferent

Indifferent

Midazolam

Buy from manufacturing

Outsource

Ketorolac

Buy from manufacturing

Outsource

Thus, under variable cost approach it is beneficial for API to outsource Cilazapril. But for Gentabs as a whole, all the molecules should be bought from manufacturing division so as to avoid unabsorbed overheads. Only in the case of capacity deficit molecules could be outsourced to the extent of deficit.

Under Full cost approach, API would gain by outsourcing all the molecules except Cilazapril as they would be indifferent to both the decisions. In case of Simvastatin there is loss of extra contribution from outsourcing decision than buying it from manufacturing department.

Thus concluding the discussion we can say that it is beneficial for both to charge the transfer prices on the basis of variable cost as there is no increase in the existing capacity.

4) How can the dispute be resolved? How can the mangers be motivated to work towards achievement of organizational goals?

a) Another main focus of the case is on behavioral implications of performance measurement and incentives system. As can be seen in the case Global API and Dosage are treated as profit centers and the divisional managers are responsible for profits. If they don't achieve the profits they will not get the bonus/incentives as Mr. SK said in the first paragraph of the case. Manufacturing department is treated as cost centre. The costs are absorbed on standard cost basis. The motive of manufacturing division manager is to not to have any unabsorbed overheads. Their actual spend is greater than the standard/budgeted spend in 2009. The differential spend shows their inefficiency. That is why they want to budget for higher costs next year.

b) These issues also point towards the conflicts which arise due to performance measurement system. On one hand, manufacturing division is overspending and Global API is making contribution. One manager will get incentives and the other will not get his share though they both are working for the same business.

c) Gentabs works in a decentralized fashion. There is no easy answer to how the dispute can be resolved. In most situations where local knowledge and fast decision-making is important, a highly decentralized system has great advantages. But with decentralization comes risks of sub optimization. This case provides one common example of sub optimization.

d) Students may ask: Is the Gentabs responsibility center/performance measurement system faulty in that it motivates managers to make decisions that are not in the best interest of the corporation as a whole? Gentabs could establish a transfer pricing policy to try to induce better transfer pricing and, hence, sourcing decisions. Such a policy could require internal transfers to be, for example, at best outside market price, or at full (or variable) cost plus a normal markup. But would such policies really lead to better organizational decision-making?

5) Should the top management interfere?

If the system is highly decentralized and managers are making their own rational decisions then we can argue that top management should not interfere. Managers have the freedom of sourcing. But if managers are allowed to take their own decisions and decide their own prices it could be detrimental to the interests of organization. Students should be encouraged to give their own viewpoints regarding interference by the top management.

Pedagogy

This case is relatively short and straightforward. Students do not need a lot of guidance to reach the conclusion that Gentabs is better off if the sourcing is done internally. Then, we suggest letting the students provide suggestions as to the best transfer price. The learning will come from the discussion of alternatives. Instructors should only intervene if students fail to recognize the advantages of decentralization.

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