Activity-Based Costing in Transfer Pricing
St. Jacob's Electronics manufactures electrical components. The company is divided into four divisions: manufacturing, residential products, commercial products, and industrial products. The manufacturing division supplies the other three divisions with all their product requirements. Because the manufacturing division has no control over product price or sales, it is treated as a cost center and transfers its products to the other divisions at full cost plus a profit margin that is intended to provide a return on capital invested in the manufacturing division. In late 1995, St. Jacob's Electronics implemented an activity costing system to develop more-accurate product costs for planning purposes. A central part of the implementation plan was to use the new costing system as the foundation for computing transfer prices. The costing system uses the four-level activity costing hierarchy: unit costs, batch costs, product-related costs, and facility-sustaining costs.
The detailed analysis of the company's cost structure revealed the following information. Most of the product-related costs were lodged in the three profit centers. The exceptions were the costs of specialized equipment housed in the manufacturing division that was used uniquely by each of the three profit centers for their products. These product-related costs in the manufacturing division were $1,500,000, $500,000, and $600,000 for the residential, commercial, and industrial divisions, respectively. The balance of the capacity-related costs in the manufacturing division, which amounted to $2,400,000 and included a charge for capital invested, were allocated to the three divisions in proportion to their long-run expected use of the facility. This amounted to 50% for the residential division, 30% for the commercial division, and 20% for the industrial division. The amount of capacity-related cost allocated to each division was the larger of amount of capacity used or amount of capacity reserved.
Each division had the right to use its reserved level of capacity. If some capacity went unused by the division for which it was reserved and was used by another division, the division not using its capacity quota was given credit for its capacity that was used by other divisions. In addition to the capacity-related costs, the manufacturing division incurred unit and batch-related costs when processing orders. All costs were charged to an order number. In this way, the cost sheet for each order accumulated the unit and batch-related costs for that order. Some products were sold by more than one division. For example, connectors were sold by all three divisions. All the connectors used the same plastic formulation but different copper or brass components. Therefore, the manufacturing division accumulated orders for connectors, and when there were sufficient orders to make a batch of plastic, the plastic was made and then used to make the connectors for the different products.
The cost of a batch of plastic included the raw materials cost and machine setup costs. Once the plastic was made, it was used to complete the various batches of connectors for the different divisions. The only common component in these connectors was the plastic. Therefore the costs of other raw materials for each connector were accumulated separately and charged directly to the product. Recently, the manufacturing division completed an order of connectors that were sold to the residential division and the industrial division. The cost of the batch of plastic was $105,000, and it was used to make 50,000 connectors of two types-each connector using the same amount of plastic. The connectors are fed into a machine that inserts the brass fittings into the connector. It costs about $2000 to set up the machine for each batch of connectors; there were 30,000 connectors made for the residential division and 20,000 connectors made for the industrial division. The cost of the brass fittings were $0.56 for each residential connector and $1.78 for each industrial connector.
(1) For each of the following use levels by the residential, commercial, and industrial divisions respectively, determine the resulting allocation of capacity-related costs:
(a) 45%, 35%, 15% (b) 45%,25%,10% (c) 45%,30%,25%
(2) What is the cost per unit for each of the residential connectors described above? Make any required assumptions to answer this question.
The Stoneland Company was in the construction business. In building its Balanced Scorecard, managers interviewed many of its current and potential customers. They found that some customers were highly price-sensitive and wanted to continue business as usual. These customers developed internally all the specifications for their bids, put the detailed bidding document out to tender, and chose, from among all qualified suppliers, the one submitting the lowest bid. As one price-sensitive customer said during an interview:
We don't have the resources of time for doing anything fancy with our suppliers. Our business has become ruthlessly competitive, with price and margin reductions in recent years, and the need for us to cut costs wherever we can. We can't afford to choose anyone but the lowest-price supplier.
Historically, Stoneland competed by attempting to be the selected low-price bidder for price-sensitive customers. But the interviews also revealed that several large and important customers were looking for more than low price from their most valued supplier of construction services. They said:
We have to cut costs wherever we can. But we are looking to our suppliers to help us in this goal. If it's cheaper and more effective for them to take over some of our engineering functions, we should let them do that, and reduce' our internal engineering staffs accordingly. We don't have any special capabilities in construction. We want suppliers that can suggest new ways of doing business, and who can develop improved technologies for this task. Our best suppliers of engineering and construction services will anticipate our needs and suggest creative ways to meet these needs through new technologies, new project management approaches, and new financing methods.
These companies acknowledged that rapidly changing technology and an increasingly competitive marketplace for their final products had motivated them to look to their suppliers for innovative ways to lower their costs. Although price would still be a factor, a supplier's ability to offer innovative and more cost-effective approaches would be a strong influence on supplier selection. Stone land referred to these companies as those wanting differentiated services.
(I) How would the customer and internal business process perspectives of Stoneland's Balanced Scorecard differ, depending on whether It selected the price-sensitive or differentiated services customer types as the target for its future strategy? Be specific about how the measures would differ depending upon which strategy Stoneland followed.
(2) What new internal business processes would Stoneland have to perform very well if it wanted to meet the expectations of its customers wanting differentiated services?
Designing an Incentive Compensation System
The executive compensation policy of the Company is based on the Company's longstanding commitment to incentive-based compensation generally for all employees, including officers. This commitment is exemplified by the cash bonus program. For many years the Company has administered a discretionary employee bonus program featuring a cash distribution determined on the basis of a formula that takes into account individual earnings and the results of a merit review process. Virtually all domestic employees participate in the program, and efforts have been made to include employees of foreign subsidiaries, when appropriate. The costs of this program, net of hospitalization costs but inclusive of payroll taxes, were $66.7 million in 1996, $66.4 million in 1995, and $59.6 million in 1994.
In 1996 the Committee directed, and management completed, a comprehensive review of the Incentive Management System that has served the Company so well for many years. The study reaffirmed the Company's commitment across the board to premium pay for premium performance and recognized the continuing importance of the piecework system to the Company's production employees. The study also acknowledged, however, the need for more vigorous performance management review and productivity gains among salaried employees and certain hourly employees; it also sought to define more clearly the connection between Company performance on the one hand and the size and equitable distribution of the cash bonus payments on the other hand.
Concurrent with the, reconfiguration of the Company's Incentive Management System (which has been renamed the Incentive Performance System), the Committee recommended a reevaluation of the Company's executive compensation policy. The Committee had begun to refine the theory of its incentive-oriented executive compensation in 1995, when it first introduced a Management Incentive Plan (MIP) for officers. One purpose of the MIP as introduced was to benchmark base salary and cash bonus opportunities against comparable opportunities at comparable companies. As first introduced, the MIP focused on establishing individual base salaries at the median of comparable companies, with a maximum incentive target, assuming achievement of predetermined financial targets, placing individuals at approximately the 75th percentile for comparable companies. The MIP was also segmented to reflect the responsibilities of individual officers, with weighing on corporate or regional results accordingly. In early 1996, the Committee set the financial performance and individual award targets for the MIP participants, including those applicable to the executive officers named in the Summary Compensation Table, on that basis.
The Committee recognized later in 1996, however, as the Incentive Management System review was completed, the need for additional improvements in the MIP and in executive compensation strategy generally. Consistent with the overall philosophy of the Company's compensation system, the Committee decided that the base salaries of MIP participants should as a norm be set at the 40th percentile, rather than the median (i.e., base salaries will be somewhat below average). The Committee has reaffirmed, however, that cash bonus opportunities should be above average, with the 75th percentile retained as the maximum target for total cash compensation. The Committee also recognized, however, that individual circumstances and performance should be factors in incentive awards, both positively and negatively notwithstanding the performance of the Company against financial targets. The financial targets for 1997 are based on earnings before interest, taxes, and the cash bonus referred to above. Financial targets were set on the same basis in 1996. An individual performance element, based upon the achievement of personal objectives, has been added to the MIP. These improvements to the MIP are effective in 1997.
The Committee also noted in its review of executive compensation that the Company had not emphasized long-term equity incentive compensation as an element of total compensation, notwithstanding the existence of the 1988 Incentive Equity Plan (the IEP), which the Committee administers. Awards under the YEP, which are made only to officers and other key employees responsible for or contributing to the management, growth, and/or profitability of the Company, may be of four types: (1) stock options, (2) stock appreciation rights attached to stock options, (3) restricted stock, and (4) deferred stock. In early 1996 the Committee approved, on a one-time basis, option grants for a total of 167,590 shares to 31 individuals in settlement of litigation arising from earlier awards under the YEP. The options were premium priced at the time of grant, with exercise prices of $30 and $34 per share. The Committee also approved in September 1996 nonqualified option grants at market for a total of 278,000 shares to 21 individuals in order to address the longer-term incentive compensation program. The Committee expects that equity compensation will be an important part of incentive compensation going forward. As of December 1996, 1,454,362 shares remained available for grant under the YEP.
Based on the information provided, evaluate the changes that Lincoln Electric made in its plans, including both the nature and the components of the plans.
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