Halcyon Group: a transfer price dispute that destroys group profit
Halcyon Group has two divisions. Instruments manufactures a sensor module; Systems assembles and sells monitoring systems. Instruments' variable cost is $84 per module and fixed costs are absorbed at $40 per module at budgeted output of 60,000. The external market price is $175, but Instruments can sell only 40,000 modules externally each year because two global suppliers dominate the market. Capacity is 70,000 modules. Systems needs 25,000 modules a year and can buy an equivalent module from an overseas supplier at $168, plus $120,000 a year in duties and freight and a history of quality problems. Transfer prices are negotiated annually between the two divisional managers, and both are paid a bonus based on divisional return on investment (divisional operating profit divided by average operating assets). Instruments' capital employed is $9.2 million. Systems has offered $120. The Instruments manager refuses anything below $175, arguing 'we will not sell below market', and has instead kept output at 40,000, leaving Systems to import. Group policy states that internal transfers must occur wherever they benefit the group.
1. Calculate the annual cost to the group of the current arrangement and the range of transfer prices that would leave both divisions and the group better off. Explain why the market price rule fails here.
Read the worked answer
Group cash cost of importing: 25,000 x $168 = $4,200,000 plus $120,000 duties and freight = $4,320,000, or $172.80 per module.
Group cash cost of internal supply: 25,000 x $84 variable cost = $2,100,000. Fixed costs are unchanged either way - they are incurred to hold capacity, not to make these particular units.
Annual loss to the group: $4,320,000 - $2,100,000 = $2,220,000, or $88.80 per module.
Acceptable price range. The general rule is: transfer price = incremental (variable) cost + opportunity cost of the transferred capacity. Instruments has 70,000 modules of capacity and can sell only 40,000 externally, so 30,000 units are idle - enough for Systems' 25,000. Opportunity cost is therefore nil.
- Floor for Instruments: $84 (below this the division is worse off supplying).
- Ceiling for Systems: $172.80 (above this it is cheaper to import).
- Any price between $84 and $172.80 improves both divisional profits and leaves the group $2,220,000 better off. The transfer price only divides the gain; it does not change the group result.
Why the market price rule fails. The $175 'market price' is achieved only on the marginal external units Instruments can sell; it is not a measure of what the spare capacity is worth. With idle capacity, the external price is not an opportunity cost - nobody is paying it for units 40,001 to 65,000. Using $175 charges Systems for a benefit no external customer would provide, and drives it to import at $172.80, destroying $88.80 of group value on every module. The rule of thumb only holds when the supplying division is at capacity and would forgo external sales.
2. The Instruments manager's refusal appears to work against his own bonus. Calculate the divisional ROI under the current arrangement and at transfer prices of $120 and $175, then explain what else is driving his behaviour and what the group should change.
Read the worked answer
Current position (40,000 external units only): contribution 40,000 x ($175 - $84) = $3,640,000, less fixed costs 60,000 x $40 = $2,400,000, gives profit $1,240,000; ROI = 1,240,000 / 9,200,000 = 13.5%.
At a $120 transfer for 25,000 units: incremental contribution 25,000 x $36 = $900,000, profit $2,140,000, ROI 23.3%.
At a $175 transfer: incremental contribution 25,000 x $91 = $2,275,000, profit $3,515,000, ROI 38.2%.
So every outcome is better for Instruments than the status quo, and refusal is not explained by the bonus formula. The manager is trading a certain, invisible gain (idle capacity) against a visible, certain price concession. Behavioural drivers to name: anchoring on the 'market price' as a fairness norm; fear that a $120 internal price will leak to external customers or become next year's ceiling; a belief that internal volume is 'subsidising' Systems; a ratchet effect where a higher profit this year raises next year's target; and a negotiation process with no arbitration, which rewards intransigence.
Design faults: a negotiated transfer price with no fallback, an ROI measure that rewards protecting the rate rather than the profit, and no group-level reporting of idle capacity or internal-sourcing performance.
Changes to make:
- Mandate internal supply where capacity is idle, with the CFO as arbiter and a documented escalation path.
- Set a formula price - variable cost plus a share of the saving, e.g. $84 + 50% of $88.80 = $128.40, or a two-part tariff of $84 plus a fixed annual fee covering the $40 absorbed cost.
- Consider dual pricing: credit Instruments at the notional market price while charging Systems the variable cost, eliminating the difference on consolidation. Group profit is unaffected and both managers face sensible signals.
- Change the measure: move to residual income and a contribution-based divisional result, and put 20-25% of each manager's bonus on group profit so that internal supply is rewarded.
- Report leading indicators monthly: idle capacity in units, percentage of Systems' requirement sourced internally, and group margin lost to external sourcing.
3. The group CFO proposes simply mandating a transfer at variable cost of $84. Evaluate this option and recommend an alternative.
Read the worked answer
It maximises short-run group profit and is administratively simple - the group result is identical whatever the transfer price, so $84 guarantees internal supply and secures the $2,220,000 saving. But it transfers the entire benefit to Systems and gives Instruments nothing for capacity, fixed cost recovery or working capital.
Consequences:
- Instruments shows no incremental margin, so its ROI stays at 13.5% while it carries the assets and the operational risk. The manager's rational response is to deprioritise internal orders when external demand improves, or to under-invest in the capacity that makes the transfers possible.
- The $40 per unit of absorbed fixed cost is stranded in Instruments with no volume-based recovery, which will look like a permanent cost overrun at year-end.
- Systems captures a windfall, which if it sets prices against that cost base could create an unsustainable pricing benchmark.
- Mandating a price without a governance mechanism simply moves the dispute one level up; it does not resolve next year's negotiation.
Better alternative - a two-part tariff. Charge Systems $84 per unit variable cost plus a fixed annual fee of about $1,000,000 (25,000 x $40) that recovers Instruments' absorbed fixed cost. Systems still pays about $124 per module in total against $172.80 to import, so it gains about $1.2 million; Instruments earns a normal return and has an incentive to hold capacity; the group keeps the full $2,220,000. A savings-share price of $128.40 achieves a similar split with less administration.
Implement with safeguards: a written three-year supply agreement with volume bands and quality/delivery service levels; a cost-review clause indexed to wage movements; a dispute escalation clause to the CFO within five business days; and a report to the audit committee on internal sourcing and idle capacity each quarter. Whichever mechanism is chosen, document the basis in the group accounting policy so that next year's negotiation starts from a rule, not from zero.