Delmorton Group: transfer pricing with scarce capacity and an ROI gate
Delmorton Group comprises two divisions. Division A manufactures component X at a variable cost of £28 and sells it on the open market at £48; its capacity is 60,000 units a year and external demand at £48 is 45,000 units. Division B assembles a product that uses a component similar to X; it needs 20,000 components a year and can buy an equivalent from an outside supplier at £44. The group's transfer pricing rule is full cost plus 10%; Division A's full cost of X is £38, so the internal price would be £41.80. Division A's manager refuses to supply B at that price, saying he is 'not a charity', and B's manager has placed an order with the outside supplier for the full 20,000 units. Separately, Division A reports controllable profit of £700,000 on capital employed of £5,000,000. The group's cost of capital is 10%. Division A's manager has identified an investment of £1,000,000 that would generate £130,000 of annual profit. His bonus is based on divisional return on investment.
1. Determine the group-optimal quantity of internal transfers and the range of transfer prices that would support it. Evaluate the full cost plus 10% rule.
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Spare capacity first. Division A has 60,000 − 45,000 = 15,000 units spare. On those units there is no displaced external contribution, so the minimum transfer price is the variable cost £28 and the maximum is B's external buying price £44. Group saving = (£44 − £28) × 15,000 = £240,000, shared anywhere in that range.
Next 5,000 units. Supplying these means giving up external sales at £48, sacrificing £48 − £28 = £20 of contribution per unit. The relevant internal cost is therefore £28 + £20 = £48, which exceeds B's outside price of £44. B should buy these 5,000 units outside; each unit transferred internally would destroy £4 of group profit (£20,000 in total).
Group optimum: transfer 15,000 internally at a price between £28 and £44; buy 5,000 from the outside supplier. Actual outcome: no transfers, B buys 20,000 outside - group profit is £240,000 lower than it need be.
The full cost plus 10% rule. £41.80 does fall inside the £28–£44 range for the spare-capacity units, so the rule would have permitted the right answer there. But it is arbitrary: it gives Division A a £13.80 margin unrelated to either its market price or its opportunity cost, and it would also apply to the scarce-capacity units, where the correct price is at least £48. A capacity-blind cost-plus rule gives A no signal about when internal business is worth having and no incentive to give it priority. Market-price-based transfer pricing with a discount for savings, or a two-part tariff with arbitration on scarce capacity, would support goal congruence.
2. Advise whether Division A's manager will accept the £1,000,000 investment and whether the group should want him to. Recommend a performance measure, referring to the transfer pricing problem above.
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ROI test (what the manager sees) Current ROI = £700,000 ÷ £5,000,000 = 14.0% After investment = (£700,000 + £130,000) ÷ (£5,000,000 + £1,000,000) = £830,000 ÷ £6,000,000 = 13.83% ROI falls, so a manager rewarded on ROI rejects a project that is genuinely profitable.
Residual income test Current RI = £700,000 − (10% × £5,000,000) = £200,000 After investment = £830,000 − (10% × £6,000,000) = £230,000, an increase of £30,000 - accept.
What the group wants. The project earns 13%, above the 10% cost of capital, so it creates £30,000 of value a year and should be accepted. ROI is the wrong measure because it is a ratio: adding an above-cost-of-capital project that earns less than the current average drags the average down. This is the same defect as the transfer pricing rule - both use an accounting ratio that ignores the marginal economics.
Recommendation. Use residual income or EVA with a properly defined capital charge and a consistent asset base (net book value applied consistently, so managers are not tempted to sell assets or defer replacement to lift the ratio). Because RI is an absolute measure it favours larger divisions, so pair it with a percentage target return and non-financial measures. Also amend the transfer pricing rule so Division A's manager is rewarded for group-optimal capacity use rather than penalised for it; otherwise he will continue to optimise divisional ratios at the group's expense.