July 8, 2013
There seems to be one thing in my life which is entirely resistant to inflation: lemonade. The Twin Cities where I live has a vast network of bike trails and hundreds of parks. While out rolling around town, you can usually find a card table with some entrepreneurial kids out selling lemonade for $.25 – the same rate we charged when I was a kid. At one table I passed, there was a little boy debating with his older sister if it was best to merely wave or if they should call out to passersby to solicit more business.
How could lemonade possibly keep a stable price between generations when everything else around us is getting more expensive? I think the answer is bad transfer cost pricing. Transfer Costs are the rates that a company charges from one division to another, usual from a manufacturing group to a distribution arm. If you think of a family unit as a business, the parents have overall P&L responsibility and the kids run satellite branches.
In lemonade sales, from the kids’ perspective, COGS are exactly zero and this has not changed over time. Any revenue generated is pure profit: there is no other revenue generating use of your time and the inputs are obtained free of cost from your parent’s kitchen. I can’t think of any parents that actually ask their kids to pay them back for supplies they use for school bake sales and lemonade stands*.
A couple of cute, out-going kids are definitely not pricing at a profit maximizing point by charging just $.25. Being forced to account for the inputs in their product sales (the cups and drink mix) would cause them to double or triple their price and they would probably experience no decrease in sales volume. (Are you really buying from your neighbor’s kids because you’re thirsty or because you want them to feel successful?)
Within a multi-national company, or even large national companies which distribute their products over wide areas, there can be similar transfer pricing issues which drive a disparity in price across regions. Whose job is it to determine internal pricing schedules? Finance, Accounting, Tax, Pricing?
Regardless of who sets the official transfer prices, the Pricers need to be aware of the incentive structure the internal pricing is driving. Pricers should know what type of profit allocation method drives the best end customer prices and maximizes profit for an organization as a whole. Sometimes, transfer costs are set so that profit margins targets at an RDC are the same as to the end customer. This promotes a sense of fairness internally – where each division is accountable for its own margin goals. Other times, transfer pricing is set high to minimize taxes on finished goods, which maximizes profits for the whole organization.
A starting point for understanding this behavior is to check out your historical transaction data for variation in COGS and Pocket Margin by Distribution Center or Sales Region. Review this data for the variation you would expect to find based on differences in market conditions versus what you actually find. If you do find gaps, as you work through the issue across departments remember, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it” -Upton Sinclar. End customer pricing may not change until the organization embraces new transfer pricing, identifying this issue may not be enough to prompt a change.
*You could argue that subsidizing lemonade stands is a conscious decision on the parents part, to get their kids out of the house and encourage them to interact in their community and to develop sales skills. There are positive externalities related to this summertime activity that wouldn’t be captured in a price waterfall diagram.