Zumwald AG

Management Accounting

Background:
Zumwald AG, headquartered in Cologne, Germany, produced and sold a range of medical
diagnostic imaging systems and biomedical test equipment and instrumentation. The company
was organized into six operating divisions. Total annual revenues were slightly more than €3
billion.

Zumwald manages ran the company on a highly decentralized basis. The managers of each
division were allowed considerable autonomy if their performances were at least on plan.
Performance was evaluated, and management bonuses were assigned, based on each division’s
achievement of budgeted targets for return on invested capital (ROIC) and sales growth. Even
though the company was partly vertically integrated, division managers were allowed to source
their components from external suppliers if they so chose.

In August 2002, a pricing dispute arose between the managers of 3 of the divisions of Zumwald
AG: Imaging Systems Division (ISD), the Heidelberg Division (Heidelberg), and the Electronic
Components Division (ECD).

The case describes a transfer pricing issue that is common in decentralized, divisionalized firms.
The case raises issues about internal pricing and, more generally, the operation of a decentralized
management structure.

Analysis 1:

If we see the facts that came out in ensuing the discussion:

X73 U

Target price
It is obvious why ISD take Display tech as their supplier, a total cost difference of € 39,500.
Thus, Heidelberg price would result in ISD negative gross margin.
Even though if we look in terms of contribution margin, ISD will still get positive numbers if
they took the display monitor from Heidelberg, but looking at the objective of having the X73 as
the next best thing in a competitive market, longer term it would not be viable for ISD to continue
having a negative gross margin.

Analysis 2:

Now if we try to analyze further on Heidelberg and ECD facts:

X73

Target price

Direct materials co
Looking at the top part, look like Heidelberg applies standard markup policy for their customers
(33.3% from its total cost). This makes the price not competitive to Display tech. As a newcomer
in the industry that look for growing its market share, obviously Display tech are willing to
compete in price.

Furthermore, if we look on bottom part, with Heidelberg still having excess capacity, especially

Others componen
in bidding process, it should apply the contribution margin concept, which they should only
consider relevant cost. In this case relevant cost would be € 50,000. With the target price of
€140,000 Heidelberg would get €90,000 contribution margin. The context of X-73 project was
clear, that it wants to acquire share in the competitive market, and it can’t compete if the price
isn’t match with what customer are willing to pay.

Answering the questions:

1. What sourcing decision for the X73 materials is in the best interest of?

a. The Imaging Systems Division?

It is better for ISD to focus on marketing the X-73 in pricing that is competitive. It is obvious that
Display tech can give better price to offer for the X-73 display monitor.
If we look at ISD contribution margin in analysis 1, it still shows a contribution (€101,700) even
though they buy the display from Heidelberg, however in a long term; X-73 may not be a
profitable product to market.

b. The Heidelberg Division?

Mr Halperin says that he needs full margin business in order to achieve his plan. In my opinion,
this is the way Mr Halperin manage his division and been emphasizing this to his salespeople.
This can be illustrated with below hypothetical figures:

Price
Maybe because of market conditions and customer price sensitivities, Heidelberg is better of
giving up some business to retain higher margins, even though they are operating in a below
capacity mode.

Full Price €
If this is the principal that Mr Halperin apply, then he should understand Mr Bauer Argument,
that his quoted price can’t compete with display tech. but if this is not case, he should have to
reduce his price by only putting relevant cost to ISD and get that bid. Strangely, he also implied
that Heidelberg engineer had helped ISD develop the X-73, and Heidelberg was reimbursed for
the cost of the engineers, but earned no profit for this work. He should’ve considered that this
assistantship does not mean that ISD will buy the display from them at any price quote.
The other option that Heidelberg might consider to bring down the cost is: looking for source
other than ECD, or asking ECD to lower down their price, but I doubt this would bring down

Cut Price €
much of the cost.

c. The Electronic Components Division?

ECD was originally established as a captive supplier to other Zumwald divisions, so in this case
eventhough ECD could quote price based on their relevant cost, and still make a contribution, but
it has established that internal pricing policy of full manufacturing cost + 20% mark up.
Overruling this policy for a 5% business could jeopardize ECD policy. zumwald other 5 division
could ask the same from ECD

d. Zumwald AG?
In the perspective of overall Zumwald AG, I would say is better off if Heidelberg supplying to
ISD, considering Heidelberg and ECD are not working in full capacity. Looking at analysis 2,
Zumwald could get a contribution margin of €90,000 from Heidelberg and €12,600 from ECD,
which is a total of €102,600. This is can be foregone if ISD order from Display tech.
In a sense, for Zumwald as a whole, getting it vertically integrated would be better off, since
opening a new market that can absorb most of the internal sourcing would benefit the whole
organization, in addition, also can close out Display tech act as Zumwald competitor in getting
more shares in monitor display market. But again, I don’t think this would create goal
congruence between the 3 divisions, as this would forfeit the decentralization that has been build
by the company and also need to be recognized that transfer pricing are just moving profits from
one divison to another. Need to be considered what is fair to all parties

2. What should Mr. Fettinger do regarding the X73 sourcing issue?

I had to advice to Mr. Fettinger to not intervene in this dispute. If the managing directors are all
making rational arguments and Zumwald is operating in a decentralized environment, then let the
managing directors have their autonomy and freedom of sourcing. We’re talking about a small
fraction (less than 5%) of the 3 division’s business. If Fettinger intervening this, then he would be
involved in many similar disputes of all the Zumwald 6 divisions. If the deal were a more
substantial part of Zumwald’s overall business, then a stronger argument can be made for
Fettinger intervention.

3. Can a system be designed to motivate each of Zumwald’s division managing directors to

take actions that are not only in the interest of their division but also in the best interest of
Zumwald?

Yes, it can, there is a possibility to establish transfer pricing policy within internal organization
(for example at variable cost plus normal markup if still have excess capacity), to induce better
sourcing decision. Of course this need to be followed by adjusted KPI for the managing directors;
otherwise this would lead to more complex dispute between them, hence goal congruence would
be hard to achieve.
In addition, of course there is also a possibility to vertically integrate some of the relevant
division to achieve optimum result for Zumwald. However, the questions remain: would those
kinds of policy really leads to better organizational decision making? It really needs to be
strategically decided weighing all risks and benefits associated.