Assignment: Analyze the Case and answer the following questions: Case Background ZUMWALD AG produced and sold a range of medical diagnostic imaging systems and biomedical test equipment and instrumentation. Below were some data about the company Consisted of 6 operating divisions 3 of them were: ○ Imaging System Division (ISD) sold ultrasound and magnetic imaging system ○ Heidelberg Division (Heidelberg) sold high resolution monitors, graphics controllers an d display subsystems 50% served ISD, 50% outside customer ○ Electronic Component Division (ECD) sold application specific integrated circuits and subassemblies. It was established as a captive supplier to other Zumwald divisions but now served outsider also •
• • •
•
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Total revenue € 3 billion Highly decentralized basis management Division performance indicators were achievement of budgeted target Return on Invested Capital (ROIC) and sales growth Partially vertical integrated Each division allowed to outsource the component
Imaging System Division (ISD) is going to launch new product namely X73 The characteristic of X73 was as follow: • •
•
It was a new ultrasound Imaging system The product was faster, cheaper and more compact Design was supported by Heidelberd division’s engineers at full cost of time compensation.
To get a best price for its component, ISD did a bidding which involved Heidelberg. Unfortunately Heidelberg bidding price was much higher than outsider company, therefore ISD decided to buy from Display Technology Plc Here is the bidding:
Supplier Heidelberg Division Bogardus NV Display Technologies Plc
Cost per X73 System (€) 140,000 120,000 100,500
The decision triggered a dispute since Heidleberg felt that ISD did not show a team work in this case.
1. What sourcing decision for the X73 materials is in the best interest of a. The Imaging Systems Division?
Base on the pricing structure X73 below are the calculation of Contribution Margin base on each suppliers’ bidding price:
Item
Price X 73
Bidding Supplier Heidelber Display d Bogardus Tech 340, 340,0 340,0 000 00 00 140,
Direct Material
000
120,0 00
00
72, Other Component Conversion cost
000
72,0 00
000
27,0 00
117, Fixed cost
000
00
00
000
336,0 00
00)
117,0 00
(16,0 Profit Margin
27,0
117,0
356, Total cost
72,0 00
27, Variable overhead
100,5
316,5 00
4, 000
23,5 00
In this case Display Tech is the best sourcing for ISD since by pricing at 340,000 per unit of X73, ISD would get highest profit compared to other offers. Heidelberg offered its standard price to ISD which would give ISD negative profit. b. The Heidelberg Division? In bidding, Heidelberg has to estimate how its competitors bid prices would be before determining its price. Hiedelber has to put only relevant cost plus a certain markup for profit to win. Bidding is a close price offer and the ethic is clear that there should be no more negotiation after the price opened. The proper price bidding for X 73 Heidelberg offers should be as follow:
Item
Direct Material
Heidelberg Current Competitive Bid Bid 21,60 21, 0 600
Conversion cost 28,40 Variable overhead
0
28, 400
55,00 Fixed cost
0
105,00 Total cost Markup (33%)
0
50 ,000
35,00
16,
0
500
140,00 Price to Offer
0
66 ,500
Fixed cost which consisted of labor cost was not relevant cost for the bidding price since even Heidelberg awarded for X73 or not, Heidelberg should pay it anyway. As its capacity currently was 70%, there was n o opportunity cost to be added. Therefore the actual lower bound Heidelberg could offer was € 50,000. However that price would give zero profit to Heidelberg. To make the profit positive, Heidelberd could do some markup (eg. 33%). This profit was beneficial for Heidelberg to cover some fixed cost. c. The Electronic Components Division? ECD has been set as internal supplier whose pricing has been standardized to that purpose. with 20% marked up from Absorption cost. This was actually the proper transfer pricing for the company in supplying to other division. Item
ECD Current 1
Manufacturing cost
8,000
Profit Margin (20%)
3,600
Price Component for X 73
2 1,600
d. Zumwald AG? Since Display Tech was the one who win bidding, from the launching of X73, Zumwald would get profit only from ISD Division amounting of € 23,500, as describe on the Calculation below
Item
Price X 73
Supplier Display Tech 340,00 0 100,50
Direct Material
0 72,00
Other Component Conversion cost
0 27,00
Variable overhead
0
Fixed cost
0
117,00
316,50 Total cost
0
23,5 Profit Margin
00
There are 2 more calculation scenario we could add if Heidelberg win the bid: 1. Heidelberg and ECD with current price offer Item Price X 73 & component Direct Material Other Component Conversion cost Variable overhead Fixed cost Total cost
ISD
Heidelber g
ECD
340,000
140,000
21,600
140,000 72,000
21,600 18,000
27,000 117,000 356,000
Profit Margin
(16,000)
28,400
50,000
18,000
90,000
Total
161,600 72,000 18,000 55,400 117,000 424,000
3,600
77,600
ECD
Total
2. Heidelberg & EDC with Transfer price, Price X73 = € 340,000 Item Price X 73 & component
ISD
Heidelber g 66,5
340,000
00
21,600 21,6
Direct Material Other Component Conversion cost
66,500 72,000
00
88,100 72,000 28,4
Variable overhead Fixed cost
27,000 117,000
00
55,400 117,000 50,0
Total cost
282,500
00
18,000
16, Profit Margin
57,500
500
350,500
3,60 0
77,600
Analysis: 1. For Zumwald AG it was important for Hedielberg to win the bidding, since it would generate more profit either Heidelberg offered current price or transfer price, 2. With first scenario ISD division would suffer for a €16,000 lost 3. If Display Tech win, Zumwald would lost € 54,100 (€77,600 – 23,500) profit 4. The first scenario it looked ISD would be the loser but in second scenario ISD would generate biger profit (assuming X73 would be priced at € 340,000)
5. With the second scenario, ISD actually could re view the X73’s price it’s, since the transfer cost allowed ISD to lower the price so that X73 could better compete in the market 6. Vertical integration rules should be set up and applied in Zumwald AG
2. What should Mr. Fettinger do regarding the X73 sourcing issue? Considering some factors as mentioned below: a. ICD has announced Display Tech as the winner. b. There was a decentralized policy among the division that Fettinger has to be respect for c. Credibility issue of the company in the eyes of outside suppliers if Fettinger i ntervene in this case by changing the decision and winning Heidelberg Mr Fettinger should let ICD to source its X73 component to Display Tech as the winner. It could become a learning for him and management. However this consideration should not base on the amount of the business which was estimated to be small, because in my opinion for a competitive product such as X73, pricing was one of important part to success. If ICD could get any better price from other division, ICD may consider a lower price to the market X73 and the revenue may be double or triple. Then Mr Fettinger has to gather his division heads with a standard policy on transfer price among the divisions. 3. Can a system be designed to motivate each of Zumwald’s division managing directors to take actions that are not only in the interest of their division but also in the best interest of Zumwald? Explain. It can. The Top Management should set a TRANSFER PRICES for internally transferred goods. However in decentralized organization such as Zumwald AG, the managing directors and his teams often have considerable autonomy in deciding whether to accept or reject orders or whether to buy inputs from inside the organization or from outside. Therefore the transfer pricing rule should promote a GOAL CONGRUENCE among the managing directors involved in the transfer Please refer to the schematic below:
There are general rules that will promote Goal congruence which are divided into scenario:
1. No excess capacity The transfer price
= Outlay cost + Opportunity cost
Outlay cost
: standard variable production cost
Opportunity cost
: forgone contribution margin from the lost sales
Goal congruence maintain because the selling company transfer its product to another division at equal price as if it sells to external customers. The buyer division just needs to pay for the above relevant costs. While Zumwald AG as the holding company would get benefit from both.
2. With Excess Capacity Transfer price
= Outlay costs (no opportunity cost to add)
Outlay cost
: standard variable production cost
General congruence: •
• •
The seller will get zero contribution since it sells the product at its outlay cost, to make it goal congruence it is advisable to allow the seller to add a markup to this lower bound in order to provide a positive contribution margin The buyer will get price at outlay costs which allow it to price lower to compete the market The Holding company off course would get more beneficial since the both division could get profit.
In this case if the transfer price policy applied among Zumwald AG’s divisions, actually the bidding is only away to compare or there is no need to do bidding at all. Heidelberg should use the above formula plus a reasonable markup to get a positive contribution margin, therefore ISD will launch X73 on its price with sufficient profit which then beneficial to Zumwald AD as the holding company. General Transfer Pricing rule provide a good conceptual model for the managerial accountant to use in setting transfer prices and in most cases it is implementable. However when the general rule cannot be implemented, it is advisable to use a transfer price based on market price, costs or negotiation.
