Advantages: the buying unit would have proper information needed for marketing and long-term decisions
Disadvantages: requires that FC be negotiated regularly, since Thompson rarely sells to Northern the resources needed for this negotiation might not be justified.
2. Negotiation
Increase communication between divisions. Currently, Northern may not know that Thompson is paying a higher then expected price for the intermediate materials they need from Southern. If Northern was aware of the amount of upstream costs and profit involved internally, it might be encouraged to forgo its own profits for the sake of the company as a whole. Profit sharing could be introduced to motivate Northern to do this.
A specified set of rules would be set up when each manager is negotiating a price. Such as if there is a match in price internally and externally, the business must be kept internally. Also if the managers cannot come to an agreement on price the outside market price will be used.
If true negotiation occurred at Birch, each division manager would have full information on markets and costs. The two divisions could negotiate a lower price for the raw material so that both units would make a contribution to their profit.
Advantages: Thompson would be free to charge a profit on any design work the division does. This process would open the lines of communication between divisions. This would be worth it to Birch since there are many transactions between Thompson and Southern.
Disadvantages: If they don’t come to an agreement they are back where they began. It may not be worth it expend these kind of resources if there are very few transactions.
Agreement among Business Units (Needed?)
Set up a mechanism for the divisions to agree on outside selling prices and for profit sharing when there is significant upstream FC and profits.
Advantage: this would solve the lack of communication and allocate upstream costs and profits.
Disadvantage: it may not be worth their time and resources.
3. Market Price
Six conditions must exist that make this alternative feasible.
Competent People
Since top management has implemented a profit center structure the company has improved its market position. It can be assumed then that the divisional mangers have both short-run and long-run interests in mind and therefore, are competent.
Good Atmosphere
Currently there are communication problems between divisions that if solved, will provide a good atmosphere. If a fair transfer price method is employed, goal congruence will increase as these managers will be motivated to meet both their divisional interests and the interest of the overall company.
A Market Price
Thompson primarily sells to outside customers; therefore, once the higher markup is omitted, his price would be close to competitive. Thompson should have included a profit amount when doing the design work for Northern. Conversely, Thompson’s sources are constrained, there isn’t a market for the intermediate products they need. Once the vice president has analysed the cost structures, each division will be more likely to offer a closer approximation to market price
Freedom to source
As mentioned in the case, each division is encouraged to either buy externally or internally. If top management puts through that acceptance order the freedom to source will be compromised. Notwithstanding, since Birch’s goal is decentralisation and this transaction represents less then 5% of volume of any division involved it is unlikely that an acceptance order will be put through.
Full Information
As mentioned there are communication problems that prevent the divisions from making marketing decisions. This should be improved so that each manager understands all the options and can make decisions that benefit both the division and the overall company. For example: Thompson buys its materials from Birch’s other divisions therefore the company will benefit overall if Northern takes Thompson’s bid. Does Northern know this?
Negotiation
With full information, proper cost structure and open lines of communication, successful negotiation will result in a fair and profitable transfer price.
Advantages: these conditions provide the best situation and can be used to improve the current method rather then try to meet all of them, therefore reducing the burden on the company. This method coincides with the highly competitive market, forcing divisions to be competitive inside and outside.
Disadvantages: as mentioned there are constraints on sourcing within Thompson’s division. Since there is no market for the intermediate products, this limits the negotiating power of Thompson. If Northern is using the bidding process they must select half the order to be done internally, since there is no evidence of this in the case, it is possible that Northern asked for bids only to get a competitive bid, therefore are the bids valid?(may not go here?) The resources needed to meet the conditions might not be justified.
ANS: (part of it). The vice president should find out which costs are really fixed for the whole company and allocate them differently. Southern’s cost structure should be reviewed to flush out the discrepancy between what Northern is expecting, and what is really happening. In this way communication between divisions will be increased to benefit the company as a whole. If he puts through an order of acceptance he will compromise both the main goal of the company (decentralisation) but also the morale of the divisions, therefore he should not put the acceptance order through,
(An additional alternative)
Arbitration and Conflict Resolution
A single executive would be assigned to settle disputes between the divisions. The executive would talk to individual division managers and then a price would be set. More formally, a committee could be set up having three responsibilities 1) Settling transfer price disputes, 2) reviewing sourcing changes, and 3) changing the transfer price rules when appropriate.
Advantages: a fair transfer price would result.
Disadvantage: this situation is not serious enough nor does it constitute enough volume of any one division to justify the resources needed to facilitate a committee.