Question

On April 20, 2001, Yan Fangjiao, general manager of the Instruments Division of Stone Group Corp. in Beijing, China, received a phone call from Lu Feng, sales representative of the Instruments Division. Feng was calling to ask Yan whether he should sell three Model HP34401A digital multimeters from the Instruments Division to the Industrial Controllers Division and what transfer price should be used if he did want to sell. Yan had to consider the appropriate accounting principles that applied in this case and the possible impact of his decision on the performance of his division. COMPANY BACKGROUND The Stone Group Corp. (Stone) was one of the largest electronics manufacturers and distributors in China. It was founded in 1984 by three men from the Chinese Academy of Science, the top research facility in China. The success of the company was based on the development of an electronic typewriter, which became the most popular such product in China. The release of this typewriter occurred when personal computers (PCs) were first appearing on the market. The product’s success was due to the fact that the typical Chinese customer purchased a computer for its word processing capabilities. The total price for a PC and a printer was over RMB40,0001 in the late 1980s, however a stand-alone electronic typewriter was only around RMB10,000. Stone marketed the typewriter as a inexpensive alternative to the computer and benefited from the lack of electronic typewriters on the Chinese market. Thanks to the success of this product, Stone had become the largest private high-tech company in China. In 1994 Stone went public with a listing on the Hong Kong Stock Exchange. As PC prices dropped in the early 1990s, Stone increasingly lost its market share. To cope with this situation, Stone began to diversify its business. By 2001, the Group’s turnover and operating profit came principally from the manufacturing, distribution and sale of computers, electronics, electrical and telecommunications products and office equipment Corporate Strategy Stone relied on the brand awareness and national-wide distribution channels that it had developed in the past years. The company was gradually shifting its business focus from the distribution of electronics and electrical engineering products, to information technology application and service, based on the Internet. They hoped this would foster a new force for competition and build a capability for sustainable growth. Stone had a three-step strategy: 1. Consolidate the product line and operation. 2. Provide value-added services to customers. 3. Transform the business focus. Stone’s first step was to readjust and consolidate the businesses of electronics and electrical products distribution. While ensuring continuous development of the current core businesses (to ensure the company’s survival), the company planned to restructure its businesses. Attention would also be directed to the technological content of Stone’s products and additional value created for its customers. Regarding value addition, Stone had developed a service capability for applications based on information technology network integration. Providing value-added services to customers was intended to help the company’s business transcend the scope of mere distribution of hardware products, to increase profit potential. Stone also established its own e-commerce business in the Internet-based service sector. They developed a unique competitive capability in marketing, logistics management, and shipping and delivery via Internet. As part of its diversification strategy, Stone took an eight per cent ownership share in Sina.com, an Internet portal company that launched Web sites in China, United States, Hong Kong and Taiwan. Sina.com had become one of the most popular portals in the Chinese community around the world. On April 13, 2000, Sina.com successfully listed on the Nasdaq. As a result, the value of Stone’s investment in Sina.com had increased substantially, which contributed significantly to the Stone results for1999. Main Distribution Groups At present, distribution of both electronic products and electrical engineering products was still the company’s main business, which comprised five categories (see Exhibit 4): 1. Printers 2. Business machinery 3. Graphic output devices 4. Electrical products 5. Industrial controllers These groups operated independently through corresponding divisions, with clients in the finance, taxation, telecommunications, transportation and construction sectors, as well as power plants and the Chinese government. Industrial Controllers This business consisted of two divisions: the Industrial Controllers Division and the Instruments Division. The Industrial Controllers Division offered online control equipment and instruments. It covered all sectors of low voltage control systems, including frequency converters, programmable controllers and temperature converters. Business partners included Fuji, Omron, Mitsubishi andSiemens. The Instruments Division provided customers with desktop electronic test and measuring instruments. These instruments included analog and digital oscilloscopes, digital multimeters, logic analysers, memory recorders and other products, which were produced by Hewlett-Packard (HP), Tektronix and Yokogawa. Stone was the second largest HP distributor in China with a 20 per cent market share. There were 11 staff members in the Instruments Division: one general manager, one vice-general manager (with three sales representatives who are responsible for Beijing area sales), another vice-general manager(with two sales representatives who are responsible for the sales in China outside Beijing), one cashier and two staff members who were in charge of logistics. THE INSTRUMENTS DIVISION AND ITS COMPETITION Each distribution group was divided into several divisions and each division operated as if it were an independent company. The division issued invoices and received payments from their clients. At the beginning of the year, each division negotiated with headquarters to establish monthly sales and gross profit quotas. Each division’s staff remuneration was calculated as a combination of a base salary and a bonus based on meeting these revenue and gross profit numbers. Furthermore, a year-end bonus was given as a percentage of the gross profit that exceeded the quota if the division’s performance was beyond both sales and gross profit quotas. Stone had a long-term co-operation contract with manufacturers. At the beginning of each year, Stone signed a purchasing agreement specifying the purchase date and quantity of each model. For HP34401A, the purchase agreement in 2001 specified the following: Typically, Stone would receive the goods at the end of the ordering month. Orders for the month of September tended to be the largest each year, due to the fact that customers completed their own investment budgets in the fourth quarter. Selling price was five per cent higher at that time and the distributors often ran out of stock in December. There were also two other HP distributors in Beijing: Oriental Integration and Zhongchu. Their purchasing and retail prices were similar to Stone’s. Zhongchu was the largest HP distributor with a 30 per cent market share. Oriental Integration was the smallest having a 15 per cent market share. HP’s instrument distributors tended to earn a low margin, with end users usually receiving a 10 per cent discount on the recommended retail price and wholesalers usually receiving a 15 per cent discount on the recommended retail price. As competition grew more intense, a customer usually asked different distributors or wholesalers for their lowest price, and made the purchase based on the best pricegiven. For digital multimeters, there were two basic categories: low end and high end. Low end referred to hand- held, usually with a display of 31⁄2 digits or 41⁄2 digits. High end referred to desktop, with a display ofmore digits and higher accuracy. HP34401A is a 61⁄2 digit multimeter. Its competition was 7802, manufactured by Wavetek, another U.S. company. 7802, distributed by Lanbo Co. Ltd. in China, was viewed by some as the most accurate 61⁄2 digit multimeter. It enjoyed high reputation and usually cost 20 per cent more than HP34401A. THE DECISION After receiving the phone call, Yan checked and found that there were 53 sets of this model left in inventory. He called the sales representative of the Industrial Controllers Division to inquire about the client. It was the Shijingshan Power Plant, a very wealthy customer, who wanted to buy nine temperature controllers worth RMB100,000 and three sets of 61⁄2 digit multimeters from the Industrial Controllers Division. However, the model of multimeter had not yet been decided and the customer asked the Industrial Controllers Division for a recommendation. In a typical case, a Stone customer could issue only one check for each order. To facilitate this, the customer needed to purchase all its desired goods from only one division of Stone. According to the Stone accounting principles, if a customer wanted to buy products from different divisions in the company, the division that obtained the most sales would issue the invoice and receive payment from the customer.This division would then buy the necessary goods from the other Stone division, or from other distributors outside of Stone to meet the client’s needs. Yan had to decide upon the appropriate transfer price to use. He knew that his division’s product was the smaller portion of the order. Therefore, his division wouldnot be able to issue the invoice. As a result, his division would receive gross profit from the sale, but would lose the sales revenue. On the other hand, the Industrial Controllers Division would receive both the sales revenue and the gross profit, if any.

QUESTION If you were Yan, what would your decision be? Why? and What are the implications of the decision?