Coffee Maker’s Incorporated (CMI) – Transfer Pricing Example

Coffee Maker’s Incorporated (CMI)


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 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 cost 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 the 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 division A and B are not happy with transfer pricing of division C as they feel that part purchased from external suppliers costs them lower than transfer price of division C and submitted a revised plan. As per 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 arise whether proposal od managers of division A and B should be accepted and will it be in the interest of the company?

Analysis:

Under current pattern total cost as regards company comes $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 cost of manufacturing of part 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 manufacturing cost of department C 2,000,000. Thus by accepting the new proposal the overall cost to the company will increase by $550,000 which means the overall profits of the company will decrease by $ 550,000.

Therefore, I suggest that the new proposal should not be implemented and company should continue with its present policy.

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