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General Appliance Corporation

Transfer Pricing, Policy & Procedure

Adena Eymael

on 15 August 2013

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Transcript of General Appliance Corporation

Stove Top Problem
Who are they?

These changes were made because of requests by the Electric Motor Division that said
"it was in the best interests of the company"

In the market however due to increased supply price was declining as production in the market exceeded demand.

Both Monsoon Controls (external) and the Electric Motor Division met the price reductions in the market.

The impact on Electric Motor Divison was a drop in before tax profit on investment from 15 % in 1984 to nearly zero in 1987

Aug 1987: Monsoon Controls after being told they would no longer supply the units decided to drop their price even further.

This resulted in a price lower than the currently agreed price set by the Electric Motor Division.

This internal price was maintained however for the rest of the year.

Oct 1987: New prices were being negotiated for 1988.

Refrigeration Division proposes a per unit price of $2.15 to match the price proposed by Monsoon Controls.

Electric Motor Division refuses to reduce its price below $2.40, the 1987 price for any of the internal division its supplies to.

Disagreement sent to Finance Staff for settlement

An integrated manufacturer of all types of home appliance

The company has a decentralised divisional organisation consisting of four product divisions, four manufacturing divisions, and six staff offices

What topics will we cover today?

Stovetop Problem

Thermastic Control Problem

Transmission Problem

Our recommended solution

Transfer Policies and Procedures?

What changes if any we would recommend?

Electric Motor Division (manufacturing) produces a Thermostatic Control Unit

Laundry Equipment Division uses these internally produced units for ALL of their requirements

In 1985 Refrigeration Division uses these units for only 25 % of their requirements

All remaining units are purchased externally from Monsoon Controls Corporation

Jan 1 1986: Chrome Products Division starts selling a chrome plate stove top unit to the Electric Stove Division

By mid 1986 complaints have been received by customers and dealers about the quality

Therefore improving quality of all products became the primary objective to fit its strategy of being a leader in the production of quality products

Manufacturing VP creates a new minimum acceptable quality

Number of rejects increases to over 80 %

Process is changed in order for stove tops to comply

By June 1987: Number of rejects decreases to less then 1%

BUT as a result manufacturing costs are deemed to have increased by .80 cents

July 1987: Chrome Products division (manufacuring) proposes a price change to Electric Stove Division (products divison) to meet this cost

Disagreement sent to Finance Staff for Settlement

Adena Eymael
Mitchell Croft
General Appliance Corporation
What is
Transfer Pricing?
In order for business units within an organisation to transact with each other (e.g. sell products from one to another) a transfer price is needed

Manufacturing and Products are jointly responsible for
a product so should share in the revenue when the product is eventually sold

Ultimately rates are negotiated between divisions themselves
BUT... if the divisions cannot agree on a price they will need to submit the dispute to finance staff for resolution
Transfer Pricing
Rates are generally based on the actual prices paid to outside suppliers for the same or comparable parts
By 1986 this percentage had increased to 50 % and by July 1987 it has increased to 75%

At the same time the Refrigeration Division informed Monsoon that from 1 Jan 1988 it would be purchasing all thermostatic control units internally.
The engineering department stated that "the proposed costs were reasonable and represented efficient processing"

Quality control stated "the quality was improved and the new parts were of superior quality to those previously supplied"
Purchasing staff stated that "there was excess capacity and as a result prices were very soft"

There was no doubt that the Refrigeration division could purchase all of their requirements at the price of $2.15 a unit or less

However purchasing stated that if purchased externally the price would end up rising to at least $2.40 as this action would dry up excess capacity
The Laundry Division produces automatic washers

Initially it had purchased its transmissions from two sources
- The Gear and Transmission Division (internal)
- The Thorndike Machining Corp (external)

Thorndike developed and engineering the transmission initially on a ten year agreement basis

After the ten years the Laundry Division would have the right to design without restriction

Two years before the end of the agreement General Appliance Corp decided to expand operations and produce all of the company's requirements and therefore not renew the contract with Thorndike.
1985: Thorndike propose a new price for the transmission and states these reductions are possible because

"they are better off taking a lower prices than abandoning purpose built machinery and they expected increased productivity"

Additionally they could also offer a low cost transmission for $10 which could be used for economy models and would be available by Jan 1 1988
Gear and Transmission division also offered to develop a unit that would be comparable in cost and performance to that proposed by Thorndike.

This proposal was accepted by letter in April 1985 between Laundry Division and Gear and Transmission.

Following this in June 1985 Gear and Transmission wrote another letter to the Laundry Division outlining features and and a price of $11.66

The letter further stated that "$11.66 will not give us our objective profit, we propose to sell you this unit for $12.00"

This letter was never acknowledged by the Laundry Division.

In 1985 based on the price of $12 Gear and Transmission submitted a proposal to top management for funding of the expansion to produce the transmission which was approved.
By late 1985 Gear and Transmission started negotiation with the Laundry Division on price - who refused to accept the price of $12, instead proposing a price of $11.21

The Finance department felt the true costs of the Thorndike unit was $11.25 which was adjusted for performance characteristics.
The price of $11.66 calculate by Gear and Transmission was in error because it failed to take into account a design feature that would reduce the cost by .50c

The purchasing staff in summary stated that in their opinion, the transmission could be obtained from Thorndike at the quoted price for the foreseeable future.

Recommended Solutions
Transfer Pricing Policies and Procedures
Transfer Pricing
As you will recall ...

Divisions are expected to treat each other independantly and therefore a price is negotiated based in actual prices paid in the market

If not agreed - the dispute is sent to the Finance Team for resolution
Source Determination
Not always feasible to act independently as product divisions didn't have the power to decide on whether to buy from within the company or outsource

A product divison was limited once the manufacturing started and infact the only way they could outsource was by obtaining permission from the manufacturing division or by disagreement

The purchasing staff had authority to settle disputes between divisions in conjuction with the Finance Department

However in nearly every case the purchasing staff had decided that the product continue to be manufactured from within the company and the price to be held at the external price.

For new parts the product division had the ability to outsource however a manufacturing division could appeal that decision if they wanted to.

Transfer Pricing Method
What changes we recommend...
Negotiation is Key
Upper Management must develop a set of rules that govern both pricing and sourcing

Line Managers should not spend an undue amount of time on transfer pricing negotiations
Structure of Finance Department
- settling transfer pricing disputes
- reviewing source changes
- changing the transfer rules when appropriate
This leads to...
As a result of the price increase...
Sent to Finance Department for Review
Focus on short term profit maximisation

Quality needs to be factored into the buying decision

Negotiation strengths and weaknesses
Presented By....
Full transcript