Cost in Supply Chains Management

Question: Discuss about the Cost in Supply Chains Management. Answer: Introduction: Transfer price can be described as the amount charged by the subsidiary or department to another subsidiary or department of a same company for transferring a product. The process of charging transfer price to the downstream departments by the upstream departments is referred as transfer pricing method. This method is very helpful for income tax implications for a company, especially multi-national companies or the companies, which have different departments under different taxation jurisdiction areas. Moreover, it proves to be beneficial for improving the efficiency level of different departments and for purchase or sales related decision-making purposes (Kaplan and Atkinson 2015). Classification of Transfer Prices: The basis of transfer prices, charged on the downstream departments, varies from company to company. According to the bases, the transfer prices can be classified into three types. The types are discussed below:- Cost-Plus Transfer Price: Cost plus transfer price is the transfer price, charged by the upstream departments on the basis of the cost, incurred by the upstream departments for processing the product with an additional margin. The transfer price is determined by adding the cost of the department with a certain profit margin (Balakrishnan et al. 2014). Cost Base Transfer Price: When the upstream departments charged only the cost of processing as the transfer price, the price is referred as cost base transfer price. In this pricing system, the last department uses to add the profit margin on the total manufacturing cost and sell the product accordingly. In this system, the intermediate departments cannot generate any operating profit (DRURY 2013). Market Rate Transfer Price: Market base pricing method is the most commonly used transfer pricing method. In this method, the transfer price is charged on the basis of the market price of the processed products. Though, it is widely used by various companies, in many cases, it becomes very difficult to get the proper market price of the processed product for every department (Seuring and Goldbach 2013). Adjusted Market Rate Transfer Price: This pricing method is a modified form of market rate transfer pricing. In this system, the companies use to compute the transfer price by adjusting the market rate according its policies and other factors. Negotiated Transfer Price: Sometimes, the departments use to decide the transfer price through negotiation with other departments. Such price is stated as negotiated transfer price (Otley and Emmanuel 2013). Reasons for Different Price Bases: Different companies use to adopt different transfer pricing methods. The selection of the proper method depends on the various aspects. Cost base method is used for simplicity and determining the accurate cost of the final product. The cost plus method is applied to allocate the total profit at different level of productions and to motivate the different individual departments. The management considers the market rates for transfer pricing to allocate the sub units at its original market price so that the cost of the final unit will be calculated according to its market rate automatically. Market rate of any product includes various risk related costs, like bad debts, insurance for damage etc. Such expenses are not applicable for transferring the sub units into another department of the company. Hence, adjusted market rate method is adopted to eliminate such expenses and apply more accurate market rate as transfer price. Negotiated pricing method is used to introduce such a price, which is acceptable by both the upstream and downstream departments and the departments should be benefitted equally (Warren et al. 2013). Purpose of Transfer Prices: As discussed above, transfer price is used for several purposes. The purposes are discussed in detail below: If the different processing units of a company are situated under different tax jurisdiction, then transfer pricing method can help the organization to calculate taxes under different tax rates more accurately. Moreover, if the selling department falls under higher tax zone, then company has to pay higher tax on the sale of the product. In that case, if the profits are distributed into different departments in different lower tax zones, then the company can pay lower tax amount (Weygandt et al. 2015). It helps the management to decide whether the sub units should be transfer to the next department or can be sold outside for higher profit margin. The management can also decide whether the sub units should be transferred from the previous department or should be bought from outside to lower the expenses. The departmental operating profit margins work as an additional motivator for the departmental staffs and managers. It can also be used as performance measurement tool to measure the efficiency level of the individual departments (Horngren et al. 2013). The transfer price, determined under cost-base transfer pricing method is very simple to calculate. However, it cannot be used for divisional performance measurement. If the transfer price is based on the cost of processing, then it cannot reflect the fair value of the transferred item. The fair value can only be determined if the cost of processing is compared with the market rate of the sub unit. Then the management can determine whether the actual processing cost is higher or it is equivalent to existing market rate (Melnyk et al. 2014). Hence, if market rate, adjusted market rate or negotiated pricing methods are used then the upstream division has to deliver the unit within the price fixed, by the management. In that case, if it incur loss or cannot achieve the budgeted profit, then the performance can be considered as poor and if it deliver the product at higher profit than the estimated profit then the performance will be treated as favorable (Fullerton et al. 2014). Moreover, the downstream department also has to receive the product at the stipulated rate and maintain its divisional operating profit at appropriate level. If it fails to achieve the targeted profit, then it will be treated as under-performed division. Calculation of Contribution Margin:- Cleaning Scraping Division Processing Division Particulars Amount Amount Selling Price p.u. 95 160 Less: Variable Costs p.u. Transfer Price -95 Direct Material -18 -5 Direct Labor -12 -10 Manufacturing Overheads -30 -10 Contribution Margin p.u. 35 40 The company should fix the negotiated transfer price at such a range, where both the units can generate equal operating margin. For the cost-base transfer price, the cleaning scraping division can earn only 9% operating margin, whereas, the processing division is getting 27% operating profit margin. If market rate is applied then the upstream division will get 26% profit margin, but the operating margin of other division will fall to 16%. In such scenario, the negotiated price should be fixed at $87.75, where both the division can generate 20% operating profit margin (Ward 2012). The calculations are shown below: Cost-Base Transfer Market-Base Transfer Negotiated Transfer Particulars Amount Amount Amount Cleaning Scraping Division: Revenue per unit 77 95 87.75 Direct Material -18 -18 -18 Direct Labor -12 -12 -12 Manufacturing Overhead: Fixed - 25% -10 -10 -10 Variable - 75% -30 -30 -30 Divisional Operating Profit 7 25 17.75 Operating Profit Margin 9% 26% 20% Processing Division: Revenue 160 160 160 Transfer Cost -77 -95 -87.75 Direct Material -5 -5 -5 Direct Labor -10 -10 -10 Manufacturing Overhead: Fixed - 60% -15 -15 -15 Variable - 40% -10 -10 -10 Divisional Operating Profit 43 25 32.25 Operating Profit Margin 27% 16% 20% Total Operating Profit 50 50 50 The lowest transfer price, acceptable by the cleaning scraping division, will be the total cost p.u. of Cruden, i.e., $70, where, the division will not earn any profit or incur any loss. It is the cost base transfer price of Cruden However, it will not be acceptable by the managers of the division. They will prefer to transfer the product at cost plus transfer price with a minimum profit margin (Rothaermel 2015). References: Balakrishnan, R., Labro, E. and Soderstrom, N.S., 2014. Cost structure and sticky costs.Journal of Management Accounting Research,26(2), pp.91-116 DRURY, C.M., 2013.Management and cost accounting. Springer. Fullerton, R.R., Kennedy, F.A. and Widener, S.K., 2014. Lean manufacturing and firm performance: The incremental contribution of lean management accounting practices.Journal of Operations Management,32(7), pp.414-428 Horngren, C.T., Sundem, G.L., Schatzberg, J.O. and Burgstahler, D., 2013.Introduction to management accounting. Pearson Higher Ed Kaplan, R.S. and Atkinson, A.A., 2015.Advanced management accounting. PHI Learning Melnyk, S.A., Bititci, U., Platts, K., Tobias, J. and Andersen, B., 2014. 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