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A lot of managers look at the product/service costs only in the manufacturing/delivering stage, making their assessments and decisions on the basis of the respective reports.

Nothing more wrong.

Before to go on with this argument, it would be useful remember what is the product/service life cycle.

It consists of 5 steps that follow:

Research & Development-Design/Engineering-Manufacturing/Delivering-Distribution/Marketing-Customer Service

It’s easy to see how to focus just on Manufacturing/Delivering stage is not typical of a competent manager.

Of course, the weight of the each stage costs depends on the industry you operate, in a sense that there are industries where the costs are concentrated on the “conception” stage (before manufacturing/delivering), just as other industries with the greatest part of their costs on the downstream stages (after Manufacturing/Delivering), just as some other firms that incur the most part of the expenses in the manufacturing /delivering processes.

The controller should be able to identify the costs inherent to each of the stages mentioned, through the collection of the data relative to that product or service.

The task isn’t so easy when in presence of generalist information system and without a specific system of reporting, but the benefits of this way of working is very tangible in the search of the best profitable decision.

How many times we observe low manufacturing costs and then we come across high costs of customer service as well as of warranty ones about the same cheap products!!

As a result of these considerations every single controller must insist on his/her top manager to set up an appropriate information system/cost management system that enables the availability of the cost data in each stage we just saw.

In many cases the costs incurred in the upstream phases as well as in the downstream ones are indirect, so that it results hard to trace them back to one product or the other.

This difficulty translates into the incapacity to find a driver by which attributing the costs incurred to the single products.

An approach fitting very well is the acivity-based costing that breaks the work of the firms into single activities, each of them characterized by one main cost determinant (driver).

First of all we map the activities of the Business Unity, then attribute the costs incurred to each activity on the basis of activity drivers and, finally,on the basis of driver amount "consumed"by each product/service  we allocate the expenses of every activity to each product/service.

Here follows an example of the last phase.

Example

Activity: Customer service (in this case call center)

Total monthly costs incurred/estimated (manly labour costs): $ 100 000

Cost driver: phone call duration per month = 800 hours

Unit Driver Cost: 100000/800 = $ 125

Phone Call time by product:

Prod        A                 B                C               D

               200             150            220            230

Call Center Costs by product

Prod        A                 B                C               D

             *25000         18750       27500      28750

*Unit driver Cost X Phone call time by product

This very simple example is made to make the concept clear and it regards both the actual costs and the future costs, that is, all I have written must be taken into account both in the actual reports and in the planning/estimation stage.

In the planning process it could seem hard to arrive at a sort of estimation about the cost driver amount by each product, particularly when you market a new one, but there are some statistical methods that could be adapted to the purpose.

This aspect falls outside the range of the article and if you have some questions, you can get in touch with me in any way you want.

Another consideration I want to make you see concerns the kind of costs I have taken.

In that example the overheads are generally fix ones, so you could ask why did you take them? Shouldn’t you have taken only the variable costs just as one does in most of decisions?

The answer is that we have to consider the long-term because of the fact the downstream phases (in our case) of the product/service life cycle unfold along a period longer than one year, and that means that all the factors tend to be variable and differential for any decision

Since the activity-based costing is the best method to calculate the full cost, that approach is to be preferred.

The different stages of a product life cycle are important also to choose the most appropriate cost management method.

I will be more clear: Which is the purpose of any firm?

The answer is to be more profitable.

And how can it do that?

The answer is by choosing an own strategy and to make it effective in the daily activity and in each phase of the life of its product/service.

Make the case of a Cost Leadership strategy, that is the search for the profitability by continuously reducing the costs.

How to translate it in terms of cost management methods?

A thinking manager should adapt them to each step of the product life cycle.

It could seem time-consuming but, again, the benefits of the consideration of every step of the life cycle are tangible in the medium term.

In the design stage (in particular when the quality research combines when the search for the cost reduction) the most appropriate approach is the Target Costing, as well as the Theory of Constraints in the manufacturing stage.

It’s not my intention either to deal with the Target Costing nor with the Theory of Constraints in this publication, so I refer you to the rich literature on them.

My goal is to highlight the role of life cycle in a simple and persuasive way.

The strategy in every aspect of the firm decisions is the purpose of my website.

For some time we have been looking at a fast change in the competitive environment in most of the economic sectors, that affects, when the business management is responsive to it, the support decision systems.

A responsive company, in fact, changes objectives or adapts them to the new scenario, changes in some case the organization structure with, as a result, a renewed structure of the costs and the need for new ways of decision making.

The overheads have increased their share within the business and the search for a higher efficiency and productivity while keeping, at least, the same level of quality of the products/services has become more and more important.

Hence the RCA springs up, by combining the concepts of the Activity Based Costing and German Marginal Cost Accounting (GPK).

It takes the activity approach from ABC and the distinction of the overheads into variable and fixed from the GPK.

The activity approach, as we know, gives a more exact way to calculate the full cost by product/service, avoiding the cross-subsidization phenomenon typical of the traditional volume-based costing system.

The distinction of overheads into variable and fixed is a means to support the decision making process both for the short term and for the long one.

Another feature taken from the GPK is the calculation of the cost of the Used  Capacity and of the Idle one, making only the costs of Used capacity chargeable to the products/services, also in the perspective of a fair pricing to the customers, without making them pay for the business planning errors/inefficiencies if any.

Moreover, the idle capacity can also mean there is a manoeuvre margin to accept potential new orders without either turning to third parts or increasing the Fixed Assets.

About this respect I remind you of the breakdown of Capacity in five categories:

• Theoretical
• Practical
• Normal
• Budget
• Used (Actual)

RCA uses the Replacement Cost taken as a basis for the depreciation expenses instead of the historical cost.

That enables the managers to reward in a realistic way the capital invested into the fixed assets of the business (it determines an higher unit fixed cost) and to make their companies, in terms of profit, more comparable with its and most recent competitors also in the perspective of a renewal of fixed assets to be more efficient and productive.

The RCA model works this way:

1. Groups the overheads accounts into Resource Pools, each of them with an own cost driver (determinant of the costs).
2. Breaks the Overheads into variable and fixed (by using if necessary statistical techniques).
3. Attributes the Resource Pool Cost to the activities.
4. Allocates the Activity Costs to the products.

The fundamental concepts for the RCA are the following:

• The resources use explains the behaviour of the costs, that is, RCA distributes the costs on the basis of the consumption of the resources.
• The resources must be considered in terms of units that express the capacity of the business unit.
• The model is an amount-based one, so the costs are firstly charged to the activities and then to products on the basis of amounts, not on the basis of percentages. That happens because, making this way, the causal relationship characteristic, which RCA  is based on, is highly satisfied.

Limitations of RCA

Like all the costing systems RCA presents some disadvantages.

In attributing the costs of the resources pools to the activities in proportion to some drivers (work hrs, mch hrs, other criterion for service companies) RCA uses an average amount, not distinguishing the existence of different salaries, fixed  asset costs, and others into the different activities /cost centers.

So, the total cost is always exact but the costs of the most expensive activities are charged to the cheapest ones, causing some difficulties of fairness in the performance evaluation of Activity managers.

To that purpose It should be used a complementary system.

That means RCA is best suitable for companies where the employees have a similar salary, where the Fixed Assets have a similar cost, that is, where the manufacturing (providing if service company) processes are more or less uniform.

Advice

Although the system is time-consuming at the implementation stage, RCA gives a lot of information  supporting in the best way many of the decisions made by managers.

For this reason, I hope RCA to be used in an actual costing system (where you wait for all the actual data, both direct expenses and indirect ones).

I mean, once you implement such an information-detailed management accounting system, it wouldn’t make sense not to wait to have a full vision of the actual costs and on the contrary proceeding through an estimation path.

Another piece of advice I want to give to improve that system is to make another distinction in the breakdown of the Capacity.

Introducing the Practical Capacity (generally higher than used one) in order to derive, as difference between practical and used capacity, the Non-Productive Capacity.

Making this way, you will be able to calculate the  cost of the "wrong" use of the Capacity.

EXAMPLE

ATTACHED YOU'LL FIND A FILE SHOWING AN EXAMPLE OF THE RCA MODEL.

It is based on assumptions concerning a manufacturing firm, but I remind you it is adaptable also to service businesses.

Cost-based methods

The topic of Transfer Pricing now concerns other methods different from the Market Price (dealt with in the previous article) that should be taken into consideration when reference market doesn’t exist and/or other specific objectives must be achieved

Here we go.

Input data for Alpha Ltd:

A = Buying Center manufacturer of product 22

V = Selling Center manufacturer of component 21 for product 22

Units of 21 required from A = 30 000

P22 = Price of Product 22 = € 26,00

Vc22 = Variable Unit costs of A to manufacture 22  product= 4,50

Fc22= Fixed Unit Costs of A =0,50

Vc21 = Variable Unit costs of V to manufacture component 21 = 11,70

Fc21 = Fixed Unit Costs of V = 2

P21 = Price of component 21 if bought from Beta Ltd (external supplier)= 20

K = Actual manufacturing capacity of V = 90 000 to 100 000 Units

Variable Cost Method

If the short-run profit is the first objective of the upper management of a group together with the goal congruence one, no method is better than Variable Cost one.

Shown below follows an example.

Exhibith 1 (Internal Transfer Price at Variable Cost of Center V)

In this case both the Center A and the whole business will achieve a positive income of € 9,80, having the goal congruence got.

The center V won’t incur a loss in the short run because it’ll sell at its variable cost of € 11,70, but it won’t get to cover the full unit cost of 13,70 in the long run and that will result in a loss.

That means, if the top management push the internal transfer at the variable costs, also because the external price for component 21 is higher (€20,00), that the motivation and the fairness of performance evaluation criteria , with reference to V, will be violated.

Full cost method

Exhibit 2 (Internal Transfer Price at Full Cost)

You see that the relevant costs, regarding the Internal Transfer, for the whole company are always the Variable Unit Costs (11,70) even if the Transfer Price equals the full unit cost of Center V (13,70).

In fact, you know that only the Variable costs (together Fixed Special ones if any) change if the manufacturing of component 21 is made.

As regards the strategic analysis, the motivation and performance evalution criteria will be violated if the internal transfer happens, because Profit Center V won’t achieve no profit neither in the short run nor in the long one.

I would highlight that the lack of motivation in the Internal Transfer Price caused by Variable Cost and Full Cost methods would be present also if the Center V was a Cost one, not a profit center as in the above examples.

The reason is very simple: if you manufacture, you incur some costs that are covered through Transfer Price if you don’t manufacture, you don’t incur those costs.

The performance evaluation, of course, wouldn’t be concerned

Turning  our attention again to the example, just the goal congruence objective will be got on the wake of the profits of the Center A, (7,80), the group ((9,80) and the Center V (0,00).

What happens if the external price of component 21 decrease to less than full cost (guess 13,00)?

Also the goal congruence criterion will be violated if the top management of the group pushes for an outside purchase, since the group will be penalized by 1,30 per unit (Relevant Variable Costs for internal Transfer of 11,70 less External Price of 13,00) , while the center A will achieve an advantage of 0,70 per unit (Internal Transfer Price from V of 13,70  less External Price of 13,00).

A better way to the Full Cost Transfer Pricing is the Activity-Based Costing (ABC) that makes the overheads allocation fairer than with the traditional costing systems.

In this regard, for deeper analysis, you can get in touch with me.

Mark-up Transfer Pricing Method

In order to achieve the motivation and performance evalution criteria the Mark-up method has been thought as one of the most appropriate.

It consists of adding a percentage to the costs taken into consideration, either variable costs or full ones, and it can push to the internal Transfer to the extent of outside price (in the example, € 20,00)

Exhibit 3 (Ouside purchase when Full Cost Mark-up Transfer Price is hIgher)

Let’s make the case Profit Center V applies the Full Cost (13,70) plus a 50% mark-up for a resulting price of € 20,55.

At these terms the external deal is advantageous only for the Buying CenterA because the outside price (20,00) is less than 20,55, whilst the Whole Business is penalized (8,30) in comparison with its Profit from an internal transfer.

You’ll note the motivation and performance criteria will be achieved both for Center A and center V, not the goal congruence (at least not at its maximum level), when the Mark-up method leads to an amount higher than external price.

Negotiated Price Method

Sometimes company use the Negotiated Price Method that leads both the Centers interested in the internal transaction to negotiate a value that satisfies both of the managers.

This causes the potential satisfaction of all the criteria (motivation, fairness of performance evaluation and goal congruence), but if a dispute arises and top management of the company intervenes, the autonomy of the BUs managers is violated.

Summing up the parts one and two of the article on the Transfer Pricing, it turns out that when there is market for the product concerned in the transaction, the Price Market is the most appropriate method to turn to, with some adjustments in constraint cases.

When there isn’t an intermediate market, the other methods have to be examined in a detailed way with reference to the strategic objectives above mentioned.

I will deal with one of the most complex topics of the world of the management control, the Transfer Pricing.

I’ll do it by adopting the usual strategic slant that focuses on this subject as a tool to achieve some of the objectives a firm set for the Business Units (responsibility centers) and for itself.

We all know that large-sized companies have internal transactions amongst their BUs so that a value is needed to be set to them, making  at the same time the interest of BUs, both buying one and selling one, and of the firm as a whole.

The transfer pricing within a multinational corporation also takes on a fiscal perspective when the internal transactions concern domestic and nondomestic BUs. In this regard the OECD has intervened by stating some general rules that must be applied to the Transfer Pricing practice.

What characterizes the content of this article doesn’t touch the fiscal side but only the compliance of Transfer Pricing decision making with the strategic aspects of the company life.

In fact, transfer price is an important factor of the performance measurement and evaluation system of the BU managers (you have to consider the transfer price as the price of goods and services in the external transactions are considered) and, as such, three elements must be considered:

1) Fairness of the measures. That is, a fair value that reflects the effort and the skills of managers must be given to the transactions, in order to assess in the best possible way their performances.

2) The methods used must motivate the managers to do better and better in the activities under their control, in a sense to reduce the costs (Buying BU) as well as the revenues (Selling BU) but also by giving to them the right autonomy to decide either to refer to the inside of the firm or to look at the market.

3) The decision ( as written above) must be made in the interest both of single BUs and of whole firm (goal congruence).

                                                                 Transfer Pricing methods

There are different methods about the determination of the Transfer Price I summarize in three categories:

1. Market Price method.
2. Cost-based methods.
3. Negotiated Price method.

The path to make the right decision begins by seeing if there is a market for the service/product of the selling center.

In particular, many semifinished products or components have no reference market  and that can affect the choice of the right Transfer Pricing method.

In the case there is the market, the most appropriate value is the MARKET PRICE if the Internal Transfer Price  is lower or equal to it.

                                                                                   Market Price

To explain this choice I cannot help but making a numerical example.

Input data for Alpha Ltd:

A = Buying Center manufacturer of product 22

V = Selling Center manufacturer of component 21 for product 22

Units of 21 required from A = 30 000

P22 = Price of Product 22 = € 26,00

Vc22 = Variable Unit costs of A to manufacture 22  product= 4,50

Fc22= Fixed Unit Costs of A =0,50

Vc21 = Variable Unit costs of V to manufacture component 21 = 11,70

Fc21 = Fixed Unit Costs of V = 2

P21 = Price of component 21 if bought from Beta Ltd (external supplier)= 20

K = Actual manufacturing capacity of V = 90 000 to 100 000 Units

Every reference to the costs in this article is to be meant as a Standard Cost. Why?

Either we are discussing about Selling center as a Cost Center or as a Profit one, or as an Investment one, it is the best way to motivate the manager by the determination of the appropriate Transfer Price.

In fact, if you take into account the actual costs, the managers of the Selling center will pass along the inefficiencies of the department to the Buying center, having little push to control costs.

The Standard Cost is the objective set as the ideal one.

In this case of the Market Price, the price determined this way must consider a similar product sold from the competitors in quality and features, as well as in credit and delivery terms.

A little rebate is conceivable in the setting of Transfer Price since there are less selling and administrative expenses, as well as larger purchase quantities.

Now we make an example, by taking the Input data listed above.

Exhibit 1 (Internal Transfer Price equal to Market Price)

In this example, of course, I don’t have considered the Fixed Costs, because they’ll remain at the same level in the short-run and you’ll note that in the row of TP of Profit center V under the column of “Whole Business”, I have put the Variable Costs of V (the only added costs for the firm as a whole if the manufacturing of 21 is made)

We note the Income is positive for both the Buying Center A and the Whole Business and the Internal TP enables the Center V to cover its Unit Variable Costs of 11,70.

The Goal Congruence is achieved this way as well as the managers are motivated to act in its own interest (of the Business Unit) by the achievement of a profit and the autonomy of making decisions (inside or outside) on the basis of any factor they hold important .

The usual performance evaluation criteria  (ROI, Revenues, Costs, Eva, Residual Income, ...) are also likely to be fair, because all the factors taken into consideration in this case are under the control of the managers (price and costs).

Furthermore, the Market Price method satisfies the arm’s length criterion, the basis for the validation of the transfer prices to fiscal purposes.

I remind you that any fiscal consideration is beyond the scope of this article and of the whole website.

Specific situation

There are cases the general profitability rule isn’t so easy to be applied and that’s the case when the Selling Center doesn’t have the capacity to manufacture the component required from the Buying center and, at the same time, to manufacture for the external market

As a result, a choice must be made.

Assume the Selling Center V has the chance of selling to an external buyer another product (23), by using  all of its available capacity  at a price of € 23,00 and with Incremental Unit Costs of € 12,70.

Exhibit 2

If an internal transfer is decided, the transaction will be made in the interest  of Center A, whilst the company as a whole will incur a loss and the profit V won’t made the best bargain. The goal congruence criterion will be violated as well as the motivation one for the Profit Center V.

Moreover, if the top-management “pushed” for an external purchase of the component 21, the autonomy criterion wouldn’t be respected.

The Market Price method in this situation has failed.

How to make the right decision in this situation?

The answer is the Minimum Transfer Price.

Minimum Transfer Price = Incremental Costs + Opportunity Costs = 11,70 + 11,30 = 23,00

This amount sends a message to A that it’s profitable for all the parts involved the external purchase of component 21 at a price below the threshold of € 23,00.

This way won’t violate any of the criteria mentioned: goal congruence, motivation (if the top management doesn’t intervene to force the external purchase, the autonomy of A will be preserved).

This method can also be used in the absence of an intermediate market .

Other considerations about the Market Price method depend on the “field” cases, every one different from the other. For your specific requirements, I would be glad to answer your queries in a private way.

In the next publication the Transfer Pricing matter will concern the cost-based methods.

The use of ROI to evaluate the performances of investment center managers is well-consolidated in the companies, so much embedded into the firm practice that many issues are undervalued.

This article points to the strategic aspects of ROI and not to the calculation of it (many ways exist in particular with reference to the denominator of the ratio Operating Profit/Assets), thereby reflecting the strategic slant of the whole website.

I remind that investment centers are those where the respective managers are in control not only of revenues and operating costs, but also of the decision making concerning the purchase of long-lived assets.

Of course in some cases the centers benefit from the advantages of shared assets and some sort of fair allocation method to each of the “users” is needed.

Just the controllability is the first factor having a strategic impact.

If you take as a reference some assets you aren’t in control of or whose allocated costs reflect an unfair allocation method, the managers of the business units (investment centers) concerned are not so motivated to improve the respective ROIs.

Another aspect important to understanding the value of ROI as a evaluation method concerns the focus of it on the short term:

1) Managers could act in a way inconsistent with the long-term goals of the BU, that is when evaluated on the basis of ROI by looking at the fiscal year, they could cut, for example, such operating expenses (r &d costs) whose benefits on the revenue side would affect the company only in the future, as well as cutting other kind of expenses not linked immediately to the revenue-generating processes but necessary to the BU activity.

2) The denominator of the ratio (Assets) is the result in many cases of the decisions of the previous managers (no longer in charge for the BU) for the share concerning the long-lived assets since the process for deciding their purchase is all but simple and short. That means that the present managers are evaluated, good or bad, on decisions they didn’t take.

3) When the decision-making process for long-term plans is based on DCF (discounted cash flows) methods, a conflict between the interests of managers evaluated on a ROI basis and the BU goals can arise. As a matter of fact, the former tend to prefer those projects most profitable in the short-term and that’s why some projects yielding most of its profits in the last part of their life and of advantage to the whole BU in the medium-long term risk to be excluded by the managers.

4) When a company has more than one investment centers with different ROIs, some projects concerning the whole organization could be rejected by the managers of the BUs with the highest ROI because lowering for one year or more that ROI. Of course, the managers of the worst performing BUs tend to encourage those projects because their ROI increase.

To solve partially all of these issues linked to the short-term focus there are some ways.

In particular, if you want to keep ROI as an evaluation indicator, an average ROI, for the last years, could be used as a reference to which comparing the “job” of the BU managers in place of the ROI of the latest period.

Another problem I want to highlight is the lacking consideration of the intangible assets in the denominator of the ratio.

For instance, nowadays and in more and more sectors, much of the competition is based on the skills of the human capital that represents the very critical success factor.

As I have just written, the usual accounting way to calculate ROI doesn’t include this element in the denominator of the ratio (assets) and, as a result, its value is overestimated.

Here, I present an attempt of my conception to calculate the value of Human Capital that derives from the  assumption skills are weighted rather fairly by the level  of compensation:

1. Determine the expected working life inside the firm, by averaging the duration of the employee career over the past years.
2. Take the labour cost in the latest Income Statement (plus or less forecasted variations in head number and salary level) and projecting it to the time period corresponding to the expected working life, as above calculated.
3. Discount the labour cost of each year at the WACC.
4. Calculate the present value of labour cost by summing the amounts of point 3.

After these steps, add the Human Capital value to the Assets (Invested capital) and calculate the new ROI.

This STRATEGIC ROI is the most realistic way and can be used as a evaluation benchmark with all of its advantages and limitations.