Laudan Advertising Agency (LAA) is based in Geeland and has three autonomous subsidiaries: A, B and C. All three subsidiaries are profit centres and LAA seeks to maximise the long-term wealth of its shareholders. A is based in Geeland, while both B and C are located in other parts of the world. LAA is a highly respected advertising agency, which in the last five years has created advertising campaigns for 25 of the world’s top 100 most recognised brands. LAA’s four key objectives published on its website are:
– To delight our clients by the quality of our work
– Provide excellent value for money to our clients
– Give our clients access to specialist and local knowledge
– Ensure our clients return to us time after time
There are three main functions within LAA:
1. Campaign management, which involves researching and understanding clients’ requirements and budgets and designing a suitable advertising campaign for them.
2. Creative design, which is where the visual appearance of the advert and graphics are created.
3. Media buying, which negotiates prices with, and buys advertising time and space from, magazine and newspaper publishers, internet search engines and TV companies.
Each subsidiary has its own department for campaign management and for media buying. Only A, however, has a creative design department.
The directors at LAA believe that without visually appealing design, any advertising campaign is unlikely to be successful and meet the expectations of the client. They identified the importance of being able to produce high quality creative design as a critical success factor for the business. Two years ago, they decided to concentrate all of LAA’s creative design at a ‘centre of design excellence’ within A. The intention was to improve the quality of creative design within the business by giving staff access to the latest design technology, and by attracting the most talented designers to work there.
To encourage the three subsidiaries to use the internal creative design department within A, instead of external third party design agencies, the directors created a new additional key performance indicator on which to appraise the performance of all subsidiaries and of subsidiary managers:
– All subsidiaries, including A, must purchase at least 90% of creative design work internally from A.
Prior to the introduction of this performance indicator, 40% of creative design work in each of the three subsidiaries was purchased from external design agencies.
The directors of LAA have become concerned that the introduction of the new key performance indicator may be causing managers to operate in ways which are not helping to meet LAA’s stated objectives. They have asked for comments from subsidiary managers (Appendix 1) about whether they have met the 90% target in the most recent period and if not, to explain why this is.
Appendix 1
Subsidiary managers’ comments on achievement of KPI for 90% creative design work purchased internally
Subsidiary A
‘A purchased 86% of design work from our internal design department in the period. It would have been almost 100%, but we won a large order for a new client who operates in a specialised industry of which we have no experience. As a result, we had to use the services of a specialised external design agency, which was much more expensive than using our in-house team.’
Subsidiary B
‘B purchased 62% of design work internally in the period. Though the quality of the designs is very good, they were more appealing to consumers in Geeland than here in Veeland, where B operates. The internal design department did not seem to understand consumer preferences in Veeland, and many of their designs were rejected by a key client of ours. As a result, an important advertising campaign missed key deadlines, by which time the internal design department had insufficient capacity to finish the work and we had to use an external agency.
‘As there is no formal transfer pricing policy in place at LAA, the basis of the transfer price charged by the internal design department is also unclear to us. It appears to be based on full cost of the design work, including apportioned overheads and an allowance for bad debts and marketing expenses, plus a very substantial mark up. We have spent a long time trying to negotiate this price with A, which is much more expensive than external designers. Furthermore, we are currently being investigated by the tax authorities here in Veeland who have indicated that the prices charged by A for design do seem well in excess of market rates.’
Subsidiary C
‘C purchased 91% of design work from the internal design department in the period, as well as achieving all our other performance targets. A key client of ours ran a major advertising campaign during the period. We used the internal design department for the first time for this campaign, instead of the usual external agency that we have used in the past for work for this client. The client was very unhappy with the extra cost that this incurred, as the number of design hours and the hourly rate was much higher than for previous campaigns. The internal design department refused to reduce the price after long negotiations and we had to give a large discount to the client before they would settle our invoice. As a result, our gross profit margin for the period was significantly reduced.
‘It would be much fairer if the transfer price charged by A was based on the market price of the services provided.’
Required:
Evaluate how the following help LAA to manage performance in order to achieve its stated objectives:
(i) identifying the critical success factor of producing high quality creative design, and
(ii) setting the key performance indicator for the requirement to purchase 90% of design work internally.
CSF of high quality design
The directors of LAA have identified the importance of producing high quality creative designs as a CSF to ensure successful advertising campaigns, and therefore client satisfaction. It is likely that having this as a CSF will help LAA achieve its objective to ‘delight clients with the quality of work’, as creative design is an important part of the service which LAA provides.
It is not clear, however, whether this CSF will help achieve the second of LAA’s objectives to provide excellent value for money. It may be that other agencies produce a similar quality of work, but charge a lower price. Alternatively, the quality of LAA’s design work may exceed that required by the client, who will be unlikely, therefore, to perceive it as good value for money.
Identifying this CSF will not directly help achieve the stated objective of providing clients with access to local and specialist knowledge. External suppliers may have more specialist knowledge than LAA can realistically replicate in its own design department.
The relationship between the quality of the creative design and the clients’ perception of its value for money will determine whether the fourth objective, to have returning clients, will be achieved or not. All other things being equal, high quality design work will probably make clients more likely to return. Other aspects of LAA’s service though, such as designing effective advertising campaigns and negotiating competitive rates for media buying, may be at least as important to the client.
KPI to buy 90% internally
Setting a KPI should lead managers to try and achieve this target, as they are appraised (and presumably rewarded) according to their performance against the target.
Having this target will only help achieve the objective of delighting clients if the quality of the design done internally exceeds that done by third party external designers. Though LAA has set up the ‘centre for design excellence’, this does not automatically mean the quality of work is any better than external agencies.
Encouraging managers to buy creative services internally does not necessarily help achieve the objective of giving value for money for clients. Managers at both B and C have indicated that the prices charged by the in-house design department are significantly higher than other agencies in the market. The use of the internal design department may not be best value for the client.
Encouraging the use of internal services may not help achieve LAA’s third objective to offer specialist and local knowledge to clients. The design department is based entirely in Geeland and may not meet the needs of clients in other countries. The manager of B has already commented that the department did not understand the requirements of consumers in Veeland. This is also inconsistent with the objectives to delight clients and to have them return to LAA.
Similarly, managers in A have also commented that the internal department did not have specialist knowledge to meet the needs of a new client. Again, encouraging managers to use the internal department seems contrary to the objectives of providing clients with specialist knowledge in order to delight them and to have them as return customers.
Assess the need for a formal transfer pricing policy at LAA.
Transfer pricing policy
Autonomy of the subsidiaries
The purposes of a transfer pricing policy are to encourage subsidiaries’ autonomy, facilitate performance evaluation and to promote overall goal congruence with the aim of LAA to maximise shareholder wealth.
As the three subsidiaries are profit centres, they will tend to make decisions which maximise their own profit. This may be at the expense of the other subsidiaries. By charging a higher transfer price to B and C for design services, A will increase its own revenue and also the costs for B and C. This may also be at the expense of LAA as a whole, for example, as C’s client was unhappy by the high charges levied by A.
A transfer pricing policy helps to prevent subsidiaries from acting in an entirely self-interested way where this may not be in the best interests of LAA as a whole. Though a transfer pricing policy should promote autonomy of the subsidiaries, LAA’s head office should have the power to impose a transfer price to maintain goal congruence across the organisation. This is not currently happening, and the high transfer prices charged for design services are causing dissatisfaction.
Both B and C have commented that they have spent large amounts of time trying to negotiate transfer prices with A. This is a waste of managers’ time. The ability of head office to impose a transfer price, or the existence of a clear transfer pricing policy, would allow managers more time to deal with other key aspects of the business, such as ensuring client satisfaction.
Performance measurement in the three subsidiaries
A transfer pricing policy will enable the performance of the individual subsidiaries to be fairly measured. If the policy is unfair, for example, the gross margin at subsidiary C was reduced by the seemingly excessive transfer prices charged by A, managers’ motivation will be reduced, especially if this reduces the subsidiaries’ managers’ rewards.
Setting clear, transparent and understandable transfer prices
Managers at B have complained that the basis for setting the transfer price from A is unclear. A transfer pricing policy should ensure that the basis for setting the prices is transparent, straightforward and well understood by managers so that they do not see prices as being set unfairly and thus become demotivated.
The basis for the prices set between subsidiaries in different countries should also be clear about how exchange rate movements are reflected in the transfer price, so that managers’ performance is not appraised on factors which are outside their control.
Also, the transfer pricing policy for transfers between different countries should ensure that the prices are likely to be acceptable to the local tax authorities. The tax authorities in Veeland, where B is located, are already investigating the transfer prices charged by A. This is presumably because the authorities suspect that the transfer price may be set at an artificially high level in order to reduce tax paid on profits earned in Veeland. Having a clear transfer pricing policy may help to demonstrate that B is operating within relevant taxation laws and is acting ethically in setting a fair transfer price. As the internal design department has no external customers, then it may be preferable to operate it as a separate cost centre and make all transfers at marginal cost.
Tutorial note: An approach which addressed the question based on the aims of a transfer pricing system, i.e. encourage autonomy, facilitate performance evaluation and promote goal congruence, would have been acceptable.
Advise the directors whether LAA should use a market value transfer price as suggested by the manager of subsidiary C.
Advantages of setting transfer prices on the basis of market value
Transfer prices on the basis of market value reflect the prices of purchasing creative design services on the open market. Both buying and selling subsidiaries will know what the market price is and be able to compare this to the price they are paying or charging internally.
Where subsidiaries have autonomy to negotiate their own transfer prices, in order to maximise the performance of the individual subsidiaries, the transfer price agreed is likely to reflect market price. The buyer will be unwilling to pay more than the price it can pay on the open market. The seller will be unwilling to charge less to sell internally than can be obtained on the open market. This encourages efficiency in A, which has to compete with external suppliers of creative design services.
Where a market value transfer price is used, it will usually be beneficial for buyer and seller, as well as for LAA as a whole, to transfer internally. This is because selling and administration costs overall for both parties are reduced, and the buyer should get better customer service and reliability of supply by buying internally.
The transfer price charged by A currently includes an allowance for marketing costs and bad debts. These are unlikely to be incurred where internal transfers are made. The costs savings may be shared by both parties and the transfer price reduced to a level below the market value. This lower transfer price is known as the adjusted market price.
If the transfer price charged by A is calculated on a different basis from market value, which appears to be the case as A’s prices are higher than the market rates, the subsidiaries will waste time arguing over the transfer price. This current approach may improve the subsidiaries’ own performance, but this is not in the best interests of LAA overall.
Disadvantages of using market price
The use of external market price will only be the optimal transfer price when a perfectly competitive external market exists. For example, though creative services can be purchased on the open market, those services may not be identical with those provided internally. Subsidiary A had to use a third party design agency for its new client as it did not have the industry knowledge to do the work itself. In this case, there may not be an equivalent service available internally to those available externally, and vice versa. There may therefore be no realistic option to buy on the open market in this situation and the use of an external market price as a transfer price would be inappropriate.
The market price may be temporary, changing according to capacity of the service providers, changes in economic
circumstances, or in the case of LAA, short-term variations in the exchange rate. In which case, the transfer price would need
to be frequently changed if it were to continue to reflect market conditions. This would be time consuming and probably
confusing to the subsidiaries’ managers.
Where allowance is made in the transfer price for the reduced costs, for example, of marketing and bad debts, it may be difficult to agree an adjusted market price which is acceptable to both A and the subsidiary purchasing design services from A.