custom freight systems a transfer pricing ldquo we can rsquo t drop our prices below 691337
Custom Freight Systems (A): Transfer Pricing
“We can’t drop our prices below $210 per hundred pounds,” exclaimed Greg Berman, manager of Forwarders, a division of Custom Freight Systems. “Our margins are already razor thin. Our costs just won’t allow us to go any lower. Corporate rewards our division based on our profitability and I won’t lower my prices below $210.”
Custom Freight Systems is organized into three divisions: Air Cargo provides air cargo services, Logistics Services operates distribution centers and provides truck cargo services, and Forwarders provides international freight forwarding services (see Exhibit 15.6). Freight forwarders typically buy space on planes from international air cargo companies. This is analogous to a charter company that books seats on passenger planes and resells them to passengers. In many cases, freight forwarders hire trucking companies to transport the cargo from the plane to the domestic destination.
Management believes that the three divisions integrate well and are able to provide customers with one stop transportation services. For example, a Forwarders branch in Singapore would receive cargo from a shipper, prepare the necessary documentation, and then ship the cargo on Air Cargo to a domestic Forwarders station. The domestic Forwarders station would ensure that the cargo passes through customs and would ship it to the final destination with Logistics Services as in Exhibit 15.6.
Management evaluates each division separately and rewards divisional managers based on profit and return on investment (ROI). Responsibility and decision making authority are decentralized. Similarly, each division has a sales and marketing organization. Divisional salespeople report
Exhibit 15.6 Custom Freight Systems’s Operations
Exhibit 15.7 Organization Chart— Custom Freight Systems
to the vice president of Operations for Custom Freight Systems. See Exhibit 15.7. Custom Freight Systems believes that it successfully motivates divisional managers by paying bonuses for high divisional profits.
Recently, the Logistics division needed to prepare a bid for a customer. The customer had freight to import from an overseas supplier and wanted Logistics to submit a bid for a distribution package that included supplying air freight, receiving the freight and providing customs clearance services at the airport, warehousing, and then distributing packages to customers.
Because this was a contract for international shipping, Logistics needed to contact different freight forwarders for shipping quotes. Logistics requested quotes from Forwarders and United Systems, a competing freight forwarder. Divisions of Custom Freight Systems are free to use the most appropriate and cost effective suppliers.
Logistics received bids of $210 per hundred pounds from Forwarders and $185 per hundred pounds from United Systems. Forwarders specified in its bid that it will use Air Cargo, a division of Custom Freight Systems. Forwarder’s variable costs were $175 per hundred pounds, which included the cost of subcontracting air transportation. Air Cargo, which was experiencing a period of excess capacity, quoted Forwarders the market rate of $155. Typically, Air Cargo’s variable costs are 60 percent of the market rate.
The price difference between the two different bids alarmed Susan Burns, a contract manager at Logistics. She knows this is a competitive business and is concerned because the difference between the high and low bids was at least $1 million (current projections for the contract estimated 4,160,000 pounds during the first year). Susan contacted Greg Berman, the manager of Forwarders, and discussed the quote. “Don’t you think full markup is unwarranted due to the fact that you and the airlines have so much excess capacity?” she asked.
Susan soon realized that Greg was not going to drop the price quote. “You know how small the margins in this business are. Why should I cut my margins even smaller just to make you look good?” he asked.
Susan went to Bennie Espinosa, vice president of Operations for Custom Freight Systems and chairperson for the corporate strategy committee. “That does sound strange,” he said. “I need to examine the overall cost structure and talk to Greg. I’ll get back to you by noon Monday.”
a. Which bid should the Logistics division accept: the internal bid from the Forwarders division or the external bid from United Systems?
b. What should be the transfer price on this transaction?
c. What should Bennie Espinosa do?
d. Do the reward systems for divisional managers support the best interests of both the Forwarders division and Custom Freight Systems? Give examples that support your conclusion.