Competitive Advantage and Transfer Pricing Gerald Smith, D.B.A.

SOURCING FROM INDEPENDENT SUPPLIERS INDEPENDENT MANUFACTURING Price$2.00 Materials Costs1.20 Labor Costs.20 Fixed Costs.40 CM ($)$.60 Total Revenue$2 million Annual Unit Sales 1 million Annual Pretax Profit$200,000 ALPHA PARTS, INC. Price$.30 Variable Costs.05 Fixed Costs.20 Contribution Margin$.25 BETA PARTS, INC. Price$.90 Variable Costs.35 Fixed Costs.40 Contribution Margin$.55

INTEGRATED MANUFACTURING Price$2.00 Materials Costs.40 Labor Costs.20 Fixed Costs1.00 CM ($)$1.40 Total Revenue $2 million Annual Unit Sales 1 million Annual Pretax Profit $200,000

PERCEPTIONS OF COSTS Breakeven Sales Change INDEPENDENT 10% Price Cut:+50% 10% Price Increase:-25% INTEGRATED 10% Price Cut:+17% 10% Price Increase:-13%

TRANSFER PRICING ISSUES WHICH COSTS ARE RELEVANT TO A PRICING DECISION? HOW DOES EXTERNAL SOURCING AFFECT RELEVANT COSTS, VIS-A-VIS INTERNAL SOURCING? WHO IS AFFECTED? HOW SHOULD FIXED COSTS BE DEALT WITH? Incremental Costs Incrementalize non- incremental costs Cost disadvantage Reliance on price instead of volume Independent's suppliers and Independent Operating decisions vs. Investment decisions

TRANSFER PRICING Objectives: 1.Transfer correct (incremental) costs 2.Maintain a profit incentive Methods: Lump sum payments High initial purchase price, that falls when volume exceeds a negotiated threshold. Pay for incremental costs, plus percent of profit from final sale.