Transfer Pricing and Divisional ROI in a Capacity-Constrained Textile Group
Shwe Textile Group has two divisions. Division A weaves fabric; Division B makes bags. A's capacity is 60,000 metres a month. External demand is 55,000 metres at MMK 12,000 per metre; variable cost is MMK 8,000 per metre. B currently buys 8,000 metres a month from an external supplier at MMK 11,500 per metre. B has received a one-off export order for 2,000 bags at MMK 65,000 per bag. Each bag needs 4 metres of fabric. B's additional variable conversion cost is MMK 30,000 per bag; no other incremental costs. B has enough capacity. A's divisional manager is evaluated on divisional ROI and refuses to sell to B below MMK 12,000, the external market price. B's manager argues that group profit would rise if A supplied at variable cost. The group finance director wants a transfer pricing policy that supports goal congruence and fair divisional performance evaluation. A's divisional assets are MMK 900 million; current divisional profit is MMK 120 million. B's assets are MMK 300 million; current profit is MMK 45 million.
1. Calculate the minimum transfer price A should charge for the 8,000 metres and the maximum B can pay. Should the group accept the export order? Show computations.
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Spare capacity = 60,000 − 55,000 = 5,000 metres. Transfer needs 8,000, so 3,000 displace external sales. Minimum TP: first 5,000 at variable cost 8,000; next 3,000 at variable cost plus lost contribution (12,000 − 8,000) = 12,000. Weighted minimum = (5,000×8,000 + 3,000×12,000)/8,000 = 9,500 per metre.
B's maximum: revenue per bag 65,000 − conversion 30,000 = 35,000 for 4 metres = 8,750 per metre. Since 8,750 < 9,500, the order cannot be done at a price acceptable to both. Group test: revenue 2,000×65,000 = 130m; costs: fabric variable 64m + lost contribution 12m + conversion 60m = 136m; group loss 6m. Reject the order.
2. Evaluate the divisional managers' arguments and show how ROI would be affected if the order were accepted at MMK 11,500. Recommend a transfer pricing policy.
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At TP 11,500: A's incremental profit = 8,000×(11,500−8,000) − 3,000×4,000 = 28m − 12m = 16m. A profit 136m; ROI 136/900 = 15.1% (up from 13.3%). B: revenue 130m − fabric 92m − conversion 60m = −22m; profit 23m; ROI 23/300 = 7.7% (down from 15%). Group profit 159m; ROI 159/1,200 = 13.25% (down from 13.75%). A's manager gains, B's loses, group loses. The managers' arguments are locally rational but not goal-congruent. Recommend a negotiated transfer price with central arbitration, or a dual price (A credited at market, B charged at variable cost, with a group adjustment), plus evaluation on residual income or group contribution rather than divisional ROI alone. Capacity and displacement should be reviewed monthly.
3. Explain how a balanced scorecard could reduce the dysfunctional behaviour, with specific measures for each division.
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Balanced scorecard should include financial and non-financial measures. For A: contribution per metre, capacity utilisation, defect/rework rate, on-time delivery to B and external customers, and energy use. For B: contribution per bag, on-time export delivery, warranty/return rate, cycle time, and customer satisfaction. Group-level: total contribution, inventory days, and quality cost. Linking bonuses to group contribution and a shared quality/delivery metric reduces the incentive to protect divisional ROI by rejecting profitable group orders. The scorecard must be updated for the capacity constraint and include a transfer-pricing dispute escalation rule.