Transfer pricing and goal congruence at Halden Precision Group
Halden Precision Group has two divisions. Components makes a bearing sold externally for £48; variable cost is £30 and practical capacity is 120,000 units a year. External demand is 110,000 units. Divisional profit is measured against £4.0m of invested capital and the Components manager's bonus depends on divisional return on investment. Assemblies buys 20,000 bearings a year externally at £42 and would rather buy internally. Group policy sets the transfer price at full cost, currently £35 a unit. The Components manager has refused to supply Assemblies, arguing that 20,000 internal units would absorb the 10,000 units of spare capacity and displace 10,000 external sales, cutting divisional profit. The group finance director accepts the arithmetic but believes the group is losing money and that the performance system, not the manager, is at fault.
1. Quantify the annual effect of the proposed internal transfer on (i) Components' divisional profit and (ii) group profit. Show your workings and explain why the manager's rational decision is not the group-optimal one.
Read the worked answer
Components, no transfer
External contribution: 110,000 × (£48 − £30) = £1,980,000
Components, 20,000 units transferred at £35
External sales fall to 100,000 units (capacity 120,000 − 20,000 internal): 100,000 × £18 = £1,800,000
Internal contribution: 20,000 × (£35 − £30) = £100,000
Total = £1,900,000, a fall of £80,000. The manager's refusal is correct on his own scorecard.
Group view
| Item | £ |
|---|---|
| External purchase avoided (20,000 × £42) | +840,000 |
| Extra variable cost (20,000 × £30) | (600,000) |
| Contribution lost on 10,000 displaced external sales (10,000 × £18) | (180,000) |
| Net group benefit | +60,000 |
The conflict is structural. The division bears the full opportunity cost of the 10,000 constrained units, but the £35 transfer price passes on none of it. The group gains because internal variable cost (£30) is well below the external purchase price (£42); the division sees only a £5 internal margin against £18 outside. The manager is optimising the measure he is paid on, which is exactly what the system rewards.
2. Recommend a transfer price or price range, and two specific changes to Halden's performance management system that would align the manager's incentives with group profit. Note one risk of each change.
Read the worked answer
Transfer price range
Components is no worse off when 20,000 × (P − £30) ≥ £180,000, so P ≥ £39. Assemblies will not pay more than its external price of £42. The economically correct range is therefore £39–£42, for example £40, which gives Components £20,000 more than its current position (20,000 × £10 = £200,000 versus £180,000 lost contribution) and still leaves the group £60,000 better off. A general formula is variable cost plus opportunity cost: £30 plus £18 on the 10,000 constrained units, averaged over the 20,000.
System changes
Replace the full-cost rule with a documented variable-cost-plus-opportunity-cost rule (or a negotiated range with the opportunity cost evidenced by sales forecasts). Risk: the opportunity cost depends on demand forecasts the supplier division controls, creating scope to overstate scarcity and inflate the price.
Assess the Components manager on residual income or a share of group profit, with the capital charge making him care about group capital and capacity use. Risk: a group-based bonus weakens individual accountability and can allow free-riding; it works only if divisional performance is still visible.
A dual pricing arrangement (credit the seller at market, charge the buyer at variable cost, absorb the difference in a group account) is a workable short-term fix, but it hides the real internal cost and can encourage uneconomic internal demand. Whichever route is chosen, the transfer price and the performance measure must be reviewed together, not separately.