PERFORMANCE EVALUATION OF BUSINESS UNITS 203
Table 13.7 Division B costs
10,000 12,000 15,000
Division B total costs 430,000 486,000 570,000
Average per unit 43.00 40.50 38.00
Reduction in average cost per unit 2.50 2.50
Reduction in selling price 4.00 7.00There are several methods by which transfer prices between divisions can be
established:
žMarket price: Where products/services can be sold on the outside market, the
market price is used. This is the easiest way to ensure that divisional decisions
are compatible with corporate profit maximization. However, if there is no
external market, particularly for an intermediate product – i.e. one that requires
additional processing before it can be sold – this method cannot be used.
žMarginal cost: The transfer price is the additional (variable) cost incurred. In
the above example, the transfer price would be £5, but Division A would
have little motivation to produce additional volume if only incremental costs
were covered.
žFull cost: This method would recover both fixed and variable costs. This has the
same overhead allocation problem as identified in Chapter 11 and would have
the same motivational problems as for the marginal cost transfer price.
žCost-plus: This method provides a profit to each division, but has the problem
identified in this example of leading to different management decisions in each
division and at corporate level.
žNegotiated prices: This may take into account market conditions, marginal
costs and the need to motivate managers in each division. It tends to be
the most practical solution to align the interests of divisions with the whole
organization and to share the profits equitably between each division. In using
this method, care must be taken to consider differential capital investments
between divisions, so that both are treated equitably in terms of ROI or
RI criteria.
In practice, many organizations adopt negotiated prices in order to avoid demo-
tivating effects on different business units. In some Japanese companies it is
common to leave the profit with the manufacturing division, placing the onus on
the marketing division to achieve better market prices.
Transaction cost economics................................
A useful theoretical framework for understanding divisionalization and the trans-
fer pricing problem is the transactions cost approach of Oliver Williamson (1975),
which is concerned with the study of the economics of internal organization.
Transaction cost economics seeks to explain why separate activities that require