Robert Burns, the president of Greetings Inc.,faced a challenging transfer pricing issue. In an effort todissuade him from increasing the transfer price for framed prints,several store managers e-mailed him with detailed analyses showinghow framed-print sales had given stores a strong competitiveposition and had increased revenues and profits. The store managersmentioned, however, that while they were opposed to an increase inthe cost of framed prints, they were looking forward to a pricedecrease for unframed prints.
Management at Wall Décor was veryinterested in changing the transfer pricing strategy. You hadreported to them that setting the transfer price based on theproduct costs calculated by using traditional overhead allocationmeasures had been a major contributing factor to its non-optimalperformance.
Here is a brief of your presentation to Mr. Burnsand the Wall Décor managers.
1. Wall Décor should decrease the transferprice for high-volume, simple print items.
2. Wall Décor should increase the transferprice for low-volume, complex framed print items.
3. Your analysis points to a transfer price thatmaintains the 20% markup over cost.
4. Adoption of these changes will provide WallDécor with an 11% return on investment (ROI), beating therequired 10% expected by Greetings' board of directors.
5. Despite the objections of the store managers,the Greetings stores must accept the price changes.
Finishing your presentation, Mr. Burns responded"Your analysis focuses almost exclusively on Wall Décor andtells us little about how to move forward and benefit the entirecompany, especially the Greetings retail stores. Let meexplain.
I am concerned about how individual storecustomers will react to the price changes, assuming the priceincrease of framed-print items is passed along to the customer.Store managers will welcome a decrease in the transfer price ofunframed prints. They have complained about the high cost of printsfrom the beginning. With a decrease in print cost, store managerswill be able to compete against mall stores for print items at acompetitive selling price. In addition, the increase in storetraffic for prints should increase the sales revenue for relateditems, such as cards, wrapping paper, and more. These are alllow-margin items, but with increased sales volume of prints andrelated products, revenues and profits should grow for eachstore.
Increasing the cost of framed prints to thestores could create one of three problems: First, a store managermay elect to keep the selling price of framed-print items the same.The results of this would be no change in revenues, but profitswould decline because of the increase in cost of framedprints.
Second, a store manager may elect to increase theselling price of the framed prints to offset the cost increase. Inthis case, sales of framed prints would surely decline and so wouldrevenues and profits. In addition, stores would likely see adecline in related sales of other expensive, high-quality,high-margin items. This is because sales data indicate thatcustomers who purchase high-quality, high-price framed prints alsopurchase high-quality, high-margin items such as watches, jewelry,and cosmetics.
Third, a store manager may elect to search theoutside market for framed prints."
Mr. Burns offered you the challenge of helpinghim bring change to the company's transfer prices so that bothbusiness units, Greetings stores and Wall Décor, win. Fromhis explanation, you could see and appreciate that setting thetransfer price for unframed and framed prints impacts sale revenuesand profits for related items and for the company overall. Youimmediately recognized the error in your presentation by simplyproviding a solution for Wall Décor alone.
The next day, marketing team provided you withthe following average data.
· For every unframed print sold (assumeone print per customer), that customer purchases related productsresulting in $4 of additional profit.
· For every framed print sold (assume oneprint per customer), that customer purchases related productsresulting in $8 of additional profit.
· Each Greetings store sets its ownselling price for unframed and framed prints. Store managers needthis type of flexibility to be responsive to competitive pressures.On average the pricing for stores is as follows: unframed prints$21, steel-framed without matting $50, wood-framed with matting$70.
1 Prepare for class discussion what you thinkwere the critical challenges for Mr. Burns. Recognize that WallDécor is a profit center and each Greetings store is aprofit center.