Alice and Jon Harrison operate two full-service dry cleaning outlets in the St. Louis metropolitan area. One of the outlets generates over $800,000 revenue per year and has more than a million dollar investment in state-of-the-art equipment. The other outlet is older, generates $20,000 revenue per month, and has 20-25 year-old equipment currently worth $85,000. Both outlets are profitable with growing market bases. Managers at each location are currently paid a base salary, and receive a year-end bonus which is five percent of total profits produced by both outlets combined. Alice has just finished a workshop on strategic business unit evaluation, and wants to change the evaluation and reward structure, hoping to motivate the two managers to produce greater revenue and profit.
Required: What type of evaluation mechanisms should she propose for the two managers? The following questions pertain to the process of transfer pricing.
1. Define the term "transfer price."
2. What the three general alternatives for setting domestic transfer prices?
3. What is meant by the term "dual pricing," as used within the context of the transfer pricing decision? Give one example of "dual pricing."
4. What criteria can be used to judge a particular transfer pricing alternative? (Hint: think about the different objectives of transfer pricing, including objectives in an international setting.)
5. What is meant by the term "advance pricing agreement" (APA)? What is the essential purpose of an APA?