Coffee Maker’s Incorporated (CMI) – Transfer Pricing Example
Two divisions of a CMI are involved in a dispute. Division A purchases Part 101, and Division B purchases Part 201 from a third division, C.
Both divisions need the parts for the products that they assemble. The intercompany transactions have remained constant for several years.
Recently, outside suppliers have lowered their prices, but Division C is not lowering its prices. In addition, all division managers are feeling the pressure to increase profit. Managers of divisions A and B would like the flexibility to purchase the parts they need from external parties to lower costs and increase profitability.
The current pattern is that Division A purchases 3,000 units of product part 101 from Division C (the supplying division) and another 1,000 units from an external supplier. The market price for Part 101 is $900 per unit. Division B purchases 1,000 units of Part 201 from Division C and another 500 units from an external supplier. Note that both divisions A and B purchase the needed supplies from both the internal source and an external source at the same time.
The managers for divisions A and B are preparing a new proposal for consideration.
- Division C will continue to produce Parts 101 and 201. All of its production will be sold to Divisions A and B. No other customers are likely to be found for these products in the short term, given that supply is greater than demand in the market.
- Division C will manufacture 2,000 units of Part 101 for Division A and 500 units of Part 201 for the Division B.
- Division A will buy 2,000 units of Part 101 from Division C and 2,000 units from an external supplier at $900 per unit.
- Division B will buy 500 units of Part 201 from Division C and 1,000 units from an external supplier at $1,900 per unit.
Division C Data 2014 Based on the Current Agreement
| Part | 101 | 201 |
| Direct materials | $200 | $300 |
| Direct labor | $200 | $300 |
| Variable overhead | $300 | $600 |
| Transfer price | $1,000 | $2,000 |
| Annual volume | 3,000 units | 1,000 units |
Required:
Computations (use Excel)
- Set up a table similar the one below to compute the difference between the current situation and the proposal for Divisions A and B. Design a different table for Division C.
| Division A | ||||||
| Current Situation | Proposal | |||||
| No. of Units | Purchase Price | Total Purchases | No. of Units | Purchase Price | Total Purchases | |
| Internal purchases | 3,000 | $ | 2,000 | $ | ||
| External purchases | 1,000 | 2,000 | ||||
| Total cost for part 101 | $ | $ | ||||
| Savings to Div. A | $ | |||||
- Summarize the financial effects for the three divisions and the company as a whole in another table.
Memo (use Word)
Write a 4- or 5-paragraph memo to the division manager explaining the analysis performed. Start with an introduction and end with a recommendation. Each of the four or five paragraphs should have a heading.
Short Essay (use Word) Start with an introduction and end with a summary or conclusion. Use headings.
- Evaluate and discuss the implications of the following transfer pricing policies:
Transfer price = cost plus a markup for the selling division
Transfer price = fair market value
Transfer price = price negotiated by the managers
Why is transfer pricing such a significant issue both from a financial and managerial perspective?
Solution
| Division A | ||||||
| Current Situation | Proposal | |||||
| No. of Units | Purchase Price | Total Purchases | No. of Units | Purchase Price | Total Purchases | |
| Internal purchases | 3,000 | $ 1,000 | $ 3,000,000 | 2,000 | $ 1,000 | $ 2,000,000 |
| External purchases | 1,000 | 900 | 900000 | 2,000 | 900 | 1800000 |
| Total cost for part 101 | $ 3,900,000 | $ 3,800,000 | ||||
| Savings to Div. A | $ 100,000 |
| Division B | ||||||
| Current Situation | Proposal | |||||
| No. of Units | Purchase Price | Total Purchases | No. of Units | Purchase Price | Total Purchases | |
| Internal purchases | 1,000 | $ 2,000 | $ 2,000,000 | 500 | $ 2,000 | $ 1,000,000 |
| External purchases | 500 | 1900 | 950000 | 1,000 | 1900 | 1900000 |
| Total cost for part 101 | $ 2,950,000 | $ 2,900,000 | ||||
| Savings to Div. A | $ 50,000 |
| Division C | ||||
| Present | Proposed | |||
| Part 101 | Part 201 | Part 101 | Part 201 | |
| Annual Volume | 3000 | 1000 | 2000 | 500 |
| Transfer Price unit | $ 1,000 | $ 2,000 | $ 1,000 | $ 2,000 |
| Transfer Price | $ 3,000,000 | $ 2,000,000 | $ 2,000,000 | $ 1,000,000 |
| Direct material | 600000 | 300000 | 400000 | 150000 |
| Direct Labor | 600000 | 300000 | 400000 | 150000 |
| Variable OH | 900000 | 600000 | 600000 | 300000 |
| Total Costs | 2100000 | 1200000 | 1400000 | 600000 |
| Profit | $ 900,000 | $ 800,000 | $ 600,000 | $ 400,000 |
| Current Position | Proposed | |||||||
| Division A | Division B | Division C | Company | Division A | Division B | Division C | Company | |
| External Purchase cost | 900000 | 950000 | 1850000 | 1800000 | 1900000 | 3700000 | ||
| Cost of Manufacturing | 3300000 | 3300000 | 2000000 | 2000000 | ||||
| Total Costs | 5150000 | 5700000 | ||||||
| Additional Cost | 550000 | |||||||
Memo
Facts:
Presently Division C is supplying 3000 part 101 to division A at $1000 each and 1000 part 201 to Division B at $2000 each. Division A is purchasing 1000 units from external suppliers at $900 each and division B is purchasing 500 units at $1900 each.
Managers of divisions A and B are not happy with the transfer pricing of division C as they feel that part purchased from external suppliers costs them lower than the transfer price of division C and submitted a revised plan.
As per the new plan, division, A will purchase 2000 units from division C, and 2000 units from an external supplier and division B will purchase 500 units from division C and 1000 units from external suppliers.
Issue:
The issue arises whether the proposal of managers of divisions A and B should be accepted and whether it will be in the interest of the company.
Analysis:
Under the current pattern, the total cost as regards the company comes to $5,150,000. The breakup of this cost is that cost for units purchased from outside suppliers by department A, and department B comes $1,850,000, and the cost of manufacturing parts 101 and part 201 of department C is $3,300,000.
If the new proposal of managers is accepted, the total cost to the company will be 5,700,000, i.e., for outside purchase, $3,700,000, and the manufacturing cost of department C is 2,000,000. Thus, by accepting the new proposal, the overall cost to the company will increase by $550,000, which means the company’s overall profits will decrease by $ 550,000.
Therefore, I suggest that the new proposal should not be implemented and the company should continue with its present policy.