Castellan Group: Transfer Pricing, Capacity and the ROI Trap
Castellan Group has two divisions. Components (Division A) can make 200,000 units a year, sells 150,000 externally at $95, incurs variable production cost of $60 and variable selling and distribution cost of $4 on external sales only, and carries fixed costs of $3.6 million. Its invested capital is $6 million; the group WACC is 12%; and the divisional manager's bonus is a direct function of divisional ROI. Assembly (Division B) needs 40,000 equivalent units a year, currently bought externally at $88, and has asked to source them internally. Division A has 50,000 units of idle capacity today but has signed letters of intent with two export customers that would absorb all remaining capacity from next year at $95. Division A's manager has also declined a $2.5 million expansion that would add 50,000 units of capacity and $350,000 of annual divisional profit, arguing it is 'not in the division's interest'. Head office is reviewing transfer pricing and divisional performance measures.
1. Compute Division A's current ROI and the minimum transfer price for this year and next year. What is the group-optimal sourcing decision in each period?
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Division A profit: contribution 150,000 × ($95 − $60 − $4) = 150,000 × $31 = $4,650,000, less fixed costs $3,600,000 = $1,050,000. ROI = $1,050,000 ÷ $6,000,000 = 17.5%, against a 12% WACC.
This year - spare capacity (50,000 units idle, 40,000 needed): no external sale is displaced, so the minimum transfer price is the incremental cost of supplying internally: $60 (the $4 selling cost is not incurred on internal sales). Any price between $60 and B's external $88 creates group value of up to $28 a unit, or $1,120,000; the negotiation range is $60–$88, and something near $74 splits the surplus evenly.
Next year - full capacity: supplying B displaces an external sale worth $95 less the $4 selling cost avoided, i.e. a net realisable $91. The minimum transfer price becomes $91. B can buy externally at $88, so an internal transfer at any price above $88 makes the group worse off. Group-optimal is: A sells all output externally, B buys its 40,000 units externally at $88. Forcing an internal deal at, say, $85 would cost the group $6 a unit, $240,000 a year, while making A's ROI look worse and B's better.
The two-period answer is the examinable point: the minimum transfer price is variable cost when capacity is idle and market price less avoidable selling costs when it is scarce, so the correct answer changes with the capacity position.
2. Analyse the rejected $2.5 million expansion and recommend how the performance measure should change.
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The project earns $350,000 on $2,500,000, a return of 14%, comfortably above the 12% WACC. But the manager compares it with the division's existing 17.5%:
- Post-investment ROI = ($1,050,000 + $350,000) ÷ ($6,000,000 + $2,500,000) = $1,400,000 ÷ $8,500,000 = 16.5%, below 17.5%.
- Residual income change = $350,000 − (12% × $2,500,000) = $350,000 − $300,000 = +$50,000.
- EVA, with the same capital charge, is also positive.
ROI therefore rejects a value-creating project, and the manager is behaving rationally given the bonus formula. This is the classic ROI underinvestment bias: the measure blends past performance with new decisions, so a high-return division is punished for growing.
Recommendations:
- Switch the bonus to residual income or EVA, or to ROI with a capital charge on new investment only, so any project above the 12% hurdle adds to the manager's score.
- Set the hurdle at the group WACC (12%), not the division's historical return, and publish that rule in advance.
- Use a balanced scorecard overlay - capacity utilisation, on-time delivery to B, and growth - so the manager is not rewarded purely for shrinking the asset base.
- Require head office sign-off on capacity decisions above a threshold, and disclose divisional capacity and forward order books in the transfer-pricing review, since A's manager holds the information advantage here.
3. What governance and behavioural risks should head office address in the transfer-pricing arrangement, and how might a two-part tariff help?
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Risks. (1) Information asymmetry: A's manager knows the export letters of intent first and can claim scarcity, or conceal spare capacity, to set the price. (2) Ratchet and hold-up: B may build an external relationship that outlasts the single year of scarcity, depriving A of an internal customer when capacity frees up. (3) Sub-optimisation through fixed-price contracts: a three-year internal deal signed at this year's variable-cost-based price locks A into $60–$70 when its opportunity cost next year is $91. (4) Blame shifting over delivery priority when A is full, which is why lead times and service levels must be in the agreement. (5) Bonus-driven distortion: A's manager is rewarded for ROI and can achieve it by refusing internal work.
Two-part tariff. B pays a per-unit price equal to A's variable cost ($60) plus an annual capacity reservation fee for the 40,000 units of capacity it requires. The fee compensates A for the option value of the reserved capacity and keeps the marginal price at variable cost, so B makes the correct make-or-buy decision at the margin and A is not penalised for holding capacity. In the scarce year, the reservation fee should reflect the $31 opportunity cost per unit ($91 − $60), which signals scarcity without distorting B's incremental decisions.
Supporting controls: an external market benchmark ($88/$95) in the transfer-pricing policy, a group-level review of any transfer above or below that range, dual pricing (A credited at market, B charged at cost) used for a defined transition period only, and a documented dispute process. The aim is to make the group-optimal decision also the individually rational one.