Academic journal article Journal of Managerial Issues

Transfer Pricing Strategies and Lot Sizing Decisions

Academic journal article Journal of Managerial Issues

Transfer Pricing Strategies and Lot Sizing Decisions

Article excerpt

Companies often use a decentralized form of organization to achieve informational and organizational efficiencies. When the decentralized segments of the organization interact, transfer prices must be established for goods and services exchanged. The determination of a transfer price is a complex issue, since the transfer price may serve multiple and often conflicting purposes. The complexities of setting a "correct" transfer price will be discussed in a later section.

The transfer-pricing problem becomes even more complex when a manufacturing segment incurs setup costs when switching from the production of one product to another product. Setup costs can be a significant element of manufacturing costs in that machines must be reset or recalibrated or chemical equipment must be cleaned of residues left from the previous process. Often technically qualified labor is required which is expensive and the lost production time can be a significant factor. The treatment of setup costs in the determination of a transfer price will affect production lot size decisions and profitability of interacting organizational segments.

If the decision is made to decentralize, the decision rights are assigned to lower levels in the organization. Zimmerman (1997) argues that while markets automatically control behavior and partition decision rights, firms must design administrative procedures to accomplish what markets accomplish automatically. In fact, a key organizational issue (if not the key issue) is how to link information and decision rights. Successful firms are able to assign decision rights to individuals in the organization who have the information required to make the decision.

To deal with the limited information processing capabilities, organizations divide into subunits called responsibility centers - cost centers, profit centers and investment centers. The degree of autonomy among the responsibility centers is a function of the firm's managerial philosophy as to the degree to which decision making is to be decentralized. The responsibility centers respond to monitoring and incentive systems imposed on them by the firm. However, not all monitoring and incentive systems achieve globally optimal solutions.

Recent trends, which have focused around JIT philosophies and continuous manufacturing flows, argue for reducing order quantities and delivering more frequently, if not continuously, in order to reduce inventories and cycle times. In the ideal JIT environment it is only at a "business unit" level that profits are meaningful. Below the "business unit" level concepts such as efficiency, quality and timeliness may not be relevant since they may motivate sub-levels to optimize at the expense of global optimization. However, reality suggests that we have a long way to go before the ideal JIT environment is achieved by all companies. Many manufacturing operations have not yet removed all of the "rocks" and must still decouple different manufacturing operations and decouple manufacturing operations from distribution operations. Inventories are used as the decoupling mechanism. Therefore, until all of the "rocks"can be removed, companies must continue to make decisions and attempt to gain operating efficiencies in this imperfect world. In the less than ideal real world many companies continue to use "profit" and "cost" centers as a part of a decentralized organizational philosophy. Therefore, it is important to the business unit's profitability that when decentralized segments of a company interact they do not suboptimize.

This article deals with the information requirements for optimal lot size/order quantity decisions and related transfer pricing policies in a decentralized manufacturing company where inventories are required and order quantities still have an impact on profitability. The article is focused on a decentralized manufacturing company for illustration; however, the concepts and conclusion can be applied to any situation where lot size decisions are impacted by external prices. …

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