Ogunpa Packaging: A Transfer Price That Destroys Group Value
Ogunpa Packaging Plc has two divisions. The Board Division makes containerboard: capacity 120,000 tonnes a year, external demand 96,000 tonnes at NGN 210,000 a tonne, variable cost NGN 118,000 a tonne, and fixed costs of NGN 4.2bn. The Cartons Division converts board into corrugated boxes and needs 30,000 tonnes a year; it can buy equivalent board locally at NGN 205,000 a tonne delivered. Group policy sets the internal transfer price at variable cost plus 10%. The Board Division's return on investment is 18.4% and its manager's annual bonus is calculated on divisional ROI. The manager has refused to supply Cartons at all, arguing that the policy price 'destroys my margin', and Cartons has been buying everything externally. Cartons has recently lost two contracts because of late delivery, and its waste rate is 6.2% against a 4% target.
1. Calculate the economically optimal sourcing position for the group and the transfer price range that supports it.
Read the worked answer
Capacity analysis. Board can make 120,000 tonnes and sells 96,000 externally, so it has 24,000 tonnes of spare capacity. Cartons needs 30,000 tonnes, so 6,000 tonnes would have to displace external sales if the whole requirement were sourced internally.
Minimum transfer price (marginal cost plus opportunity cost).
- First 24,000 tonnes: no external sales are displaced, so the minimum is variable cost, NGN 118,000 a tonne.
- Remaining 6,000 tonnes: each tonne transferred forgoes external contribution of NGN 210,000 - 118,000 = NGN 92,000, so the minimum is NGN 118,000 + 92,000 = NGN 210,000 a tonne.
Maximum transfer price. Cartons' external purchase price, NGN 205,000 a tonne.
Conclusion. For 24,000 tonnes there is a deal range of NGN 118,000-205,000 and internal supply is clearly right: group saving = 24,000 x (205,000 - 118,000) = NGN 2,088m a year. For the last 6,000 tonnes the minimum (NGN 210,000) exceeds the maximum (NGN 205,000), so no internal trade should take place: group cost of internal supply is NGN 210,000 (variable cost plus forgone contribution) against NGN 205,000 external, so buying outside is NGN 5,000 a tonne cheaper - NGN 30m a year better.
Optimal group position: Board sells 96,000 tonnes externally, transfers 24,000 tonnes to Cartons, and Cartons buys 6,000 tonnes externally. Total board cost to the group = 24,000 x 118,000 + 6,000 x 205,000 = NGN 4,062m, against NGN 6,150m if Cartons bought all 30,000 externally - an annual gain of NGN 2,088m that the current policy is throwing away.
2. Explain why the current policy produces this outcome and recommend a performance measurement and transfer pricing design that aligns the managers.
Read the worked answer
Why it fails. The policy price of NGN 129,800 (118,000 + 10%) is below Board's marginal cost including opportunity cost for every tonne it supplies beyond spare capacity, and is far below the NGN 210,000 external price on which the manager's ROI is built. Because his bonus is divisional ROI, he is rational to refuse: every tonne transferred at NGN 129,800 dilutes his return relative to selling outside. The cost-plus formula also gives Cartons no incentive to source internally at the margin and gives Board no reward for capacity planning. The result is a group loss of roughly NGN 2.1bn a year, invisible in divisional reports because each division appears to be optimising its own numbers.
Design options.
- Two-part (dual) transfer pricing. Credit Board at market (NGN 210,000) and charge Cartons at variable cost (NGN 118,000); the difference sits in a group suspense account eliminated on consolidation. Each manager then faces the right marginal signal, and the group bears the mismatch transparently.
- Residual income or EVA instead of ROI. Charge each division a capital charge on assets employed so that any contribution above the charge adds to the bonus. This removes the ROI incentive to reject profitable incremental volume - the classic under-investment problem.
- Group-level sourcing mandate. Where a group optimum conflicts with divisional metrics, the board can mandate internal supply for the 24,000 tonnes and adjust bonuses for the mandated volume, with the transfer price set at variable cost plus a share of the group gain.
Governance. Publish the sourcing rule, review transfer prices annually against external benchmarks, and make the group's share of the gain visible to both managers so that cooperation is rewarded rather than punished. Add a review of whether Cartons' 6,000-tonne external purchase is at genuine arm's length.
3. Propose the performance measures Ogunpa should add to address the delivery failures and waste, and explain how they fit a balanced scorecard.
Read the worked answer
Diagnosis first. Lost contracts and a 6.2% waste rate against a 4% target are internal-process symptoms; the financial measures currently in use (ROI, cost per tonne) cannot see them until revenue is lost. The scorecard should make the causal chain explicit: process performance drives customer outcomes, which drive financial results.
Internal process perspective. Waste rate per production run and per tonne input; machine downtime and changeover time; first-pass yield; percentage of board produced within specification. Target the waste gap explicitly - closing 2.2 percentage points on 30,000 tonnes at NGN 118,000 a tonne is roughly NGN 78m a year of material, a concrete financial link.
Customer perspective. On-time-in-full delivery against the promised lead time; order-to-despatch cycle time; customer complaints and credits; contract retention. The two lost contracts should be recorded as a leading indicator and tracked to root cause (scheduling versus Board's delivery reliability).
Learning and growth. Operator training hours and certification, safety incidents, and cross-divisional scheduling capability - the transfer-pricing conflict is itself a capability problem.
Financial perspective. Contribution per tonne, ROI and residual income at divisional level, and the group-level gain realised from internal sourcing.
Implementation points. Keep the set to roughly 12-15 measures, each with a defined formula, owner, data source and target; review monthly; and make sure the bonus scorecard weights reflect what the group actually needs - if delivery reliability is the strategic constraint, it must carry real weight in the managers' bonuses, not sit in a dashboard nobody is paid on. Verify that the waste data is captured consistently between divisions before it becomes a target.