Question

Shop and Save (S&S) is a large grocery chain with 350 supermarkets. Twenty-eight S&S stores are located within the Detroit metropolitan region and serviced by the S&S Detroit Bakery, a large central bakery producing all of the fresh-baked goods (breads, rolls, donuts, cakes, and pies) sold in the 28 individual S&S stores in the Detroit region. Besides selling S&S baked goods, the stores also sell other nationally branded commercial baked goods both in the baked goods section of the store and in the frozen section as well. But all freshly baked items sold in the 28 S&S stores come from the S&S Detroit Bakery. Each store orders all the baked goods from the S&S Detroit Bakery the day before. The S&S Detroit Bakery also is a profit center and sells only to the 28 Detroit S&S stores. Each store pays the bakery 60 percent of the retail selling price. So. for example, if a store manager orders from the bakery a loaf of whole grain bread that has a retail price of $5.00. that store is charged $3.00 (60% × $5.00) and the Detroit Bakery records revenues of $3.00.

Each store manager is evaluated and compensated as a profit center and has some decision rights over the particular items stocked in each store. But roughly 85 percent of all SKUs (stock keeping units) carried by each store and the retail price of each SKU are dictated centrally by the S&S Detroit Regional headquarters, which oversees both the 28 stores and the bakery. Each store manager has decision rights over the quantity of the various baked goods ordered from the S&S Detroit Bakery. The retail price of each freshly baked item produced by the S&S Detroit Bakery and sold in the grocery stores is set by the Detroit Regional headquarters, not the individual grocery stores or the S&S Detroit Bakery.

The manager of the Detroit Bakery complains that the reason her central bakery loses money is that the 60 percent rate is too low to cover her costs. The individual grocery store managers complain that the quality and variety of fresh baked goods they receive from the S&S Detroit Bakery are not competitive with high-end private specialty bake shops in the Detroit area.

1. Evaluate the advantages and disadvantages of the S&S policy of each S&S grocery store paying the S&S Detroit Bakery 60 percent of the retail price of the bakery item.

2. Suggest ways that S&S can improve the relationship between its grocery stores and its central bakery.

Answer 1

a. Advantages:

• No gaming over the transfer price. It is objectively set by central management. The Bakery cannot game the system by substituting variable costs for fixed costs if a variable cost transfer pricing method was used for instance.

• The transfer pricing policy is simple and easy to understand.

• The Bakery has an incentive to produce efficiently since it cannot pass inefficiencies on to the stores through higher transfer prices if they were using a cost-based transfer price.

Disadvantages:

• The optimum, firm-value maximizing transfer price is opportunity cost. With excess capacity, marginal (or variable) cost is the opportunity cost. There is no guarantee that 60 percent of the retail price is marginal cost. Moreover, it is unlikely that marginal cost is always 60 percent of the price across all fresh baked goods (breads, rolls, cakes, and pies).

• The current pricing policy does not utilize any of the specialized knowledge of the local stores nor of the Bakery in determining the transfer price.

• Decision rights over the transfer pricing of the baked goods are set centrally, but the Bakery is evaluated as a profit center. Hence, the performance evaluation and reward structure of the Bakery does not match the Bakery’s decision rights assignment.

b. They can continue to use the 60 percent of retail price as the transfer price of current bakery items but allow the stores and bakery to negotiate the transfer price of new bakery items. In this way the stores that have specialized knowledge of what consumers want and the stores that have specialized knowledge of recipes and current trends in baked goods can assemble this knowledge and negotiate over the transfer price.

Another suggestion is to allow the stores to purchase some fresh baked goods from local bakeries. This forces the bakery to become more competitive in terms of specialty baked goods at competitive prices.

Finally, S&S should prepare a market study of the wholesale prices of fresh baked goods in the region. If the wholesale price of most fresh baked goods is roughly 60 percent of the retail price, then the internal transfer price of 60 percent of the retail price is roughly the market price and hence is probably a good approximation of opportunity cost.

Other solutions include: decentralize the pricing decision to the Bakery/grocery stores or make the Bakery a cost center. However, before implementing either of these suggestions, one needs to ask: “Is the current system broken?”