Accounting
Transfer Pricing Case Study; Coffee Makers Incorporated
The decision to make or purchase a good that can, or already is supplied internally requires careful consideration. Different departments may look at the issue differently, especially if the internal transfer pricing does not reflect the market conditions. However, although different departments may have different budgets, the firm will also need to take a broader view and consider the bottom line for the firm.
In this case Coffee Makers Incorporated (CMI) is considering the position of three divisions; Divisions A and B. are both buying parts from Division C. Division A buys part 101, for a transfer price of $1,000, and Division B. buys part 201 for a transfer price of $2,000. Both divisions are under pressure to increase their profitability so when the opportunity for division A to purchase part 101 externally for $900, and division B. has the opportunity to purchase part 201 from an external supplier for $1,900, they wish to move more purchases, as this would help to increase their own profitability. The aim of this paper is to assess the current position and then look at the potential of new proposals for more f the parts to be purchased from external suppliers at the lower cost.
The Current Scenario
Before looking at the individual division, it is useful to look at the current costs to Division C, and calculate the total variable cost and the contribution (transfer price - variable cost). The contribution is the gross profit of the product.
Table 1; Contribution for each part for Division C
Transfer price
1,000
2,000
Direct material
Direct labor
Variable overhead
Total variable costs
Contribution per unit
The next consideration is the existing position of the firm, and the total net cost to the firm, calculation to net cost to the firm for each division. To calculate the total spent by the division A, it is known that they currently purchase 3,000 units from Division C. And another 1,500 units from an external supplier.
Table 2; Current costs for division A
Supplier
No. Of units purchased
Cost per unit
Total purchase costs
Division C
3,000
1,000
3,000,000
External source
1,500
1,350,000
Total
4,000
4,350,000
With 3,000 units purchased internally, the next stage is to calculate the total contribution that goes towards the firm from those internal purchases. This is shown in table 3.
Table 3; Contribution created by divisions A's purchases
No of units purchased
Contribution per unit generated (calculated in table 1)
Total contribution
3,000
900,000
The net cost to the company can be determined by taking the total cost and deducting the contribution earned, shown in table 4.
Table 4; Net cost to the firm for Division C. purchases
Costs for Division A (table 2)
4,350,000
Less contribution from Division C (table 3)
900,000
Net cost to firm
3,450,000
The same approach is used to calculate the net cost to the firm for the purchases of Division B. The current purchase price is calculated with the assumption that Division B. currently purchasing 1,000 united from Division C. And another 500 from an external supplier. The cost is shown in table 5 below.
Table 5; Cost of Division B. purchases
Supplier
Units purchased
Cost per unit
Total costs
Division C
1,000
2,000
2,000,000
External supplier
1,900
950,000
Total
2,000
2,950,000
With 1,000 units purchased from division A, the next step is to determine the contribution level that is earned by division C. For the transaction.
Table 6; Contribution created by divisions B's purchases
No of units purchased
Contribution per unit generated
(from table 1)
Total contribution
1,000
800,000
This can then be deducted from Division B's costs to give a net cost to the firm
Table 7; Net cost to the firm for Division B's purchases
Costs for department A
2,950,000
Less contribution from dept. C
800,000
Net cost to firm
2,150,000
Under the current arrangement the current total net costs to the firm for parts 101 and 201 is show in table 8.
Table 8; Total costs
Net costs for Division A
3,450,000
Net costs for Division B
2,150,000
Total net cost
5,600,000
The Proposed Changes
The proposals are for each division...
The result is the purchase of 2,000 from division C, then buying 20,00 from an external supplier, at a cost of $900. It should be noted we cannot undertake a direct competition, as they are reducing their total purchase, which is currently 4,500 to 4,000.
Table 9; New costs for Division A
Supplier
Units purchased
Cost per unit
Total costs
Division C
2,000
1,000
2,000,000
External supplier
2,000
1,800,000
Total
4,000
3,800,000
This is immediate lower that the current total cost; this is partly because of the reduced total volume purchase (500 less) and the lower external cost. The main change is that there is the loss of 1,000 units to division C, which means the firm will not earn that contribution, and the gaining of lower prices for department A for the additional 500 being purchased. Then net impact on the firm of the shift in purchasing patterns can be seen in table 9.
Table 10; Changes resulting from Division A purchases
Change
Loss/gain per unit
Net change
-1,000
-300000
50000
Total
-250,000
This shows that although Division A may be saving money, the 50,000 shown in able 9 (line 2), the net impact on the firm is negative due to the lost internal sales and lost contribution and the total impact will be a loss t division C. Of $250,000.
The proposal from Division is also to shift more purchases away from Division C, so only 500 units are purchased from division C. And 1,500 units will be purchased from an external supplier. It should be noted here that there is a change, and while Division A was reducing its overall purchases, Division C. is increasing its overall purchases by 500. The new tttal cost for division B. is shown in table 10 below.
Table 11; New costs to Division B
Supplier
Units purchased
Cost per unit
Total costs
Division C
2,000
1,000,000
External supplier
1,500
1,900
2,850,000
Total
2,000
3,850,000
As the purchase numbers are not the same, moving from 1,500 for the current position to 2,000 with the new purchases, so this shows an increase, despite the overall reduction in costs per unit.
To assess the impact on the firm, a direct competition is not appropriate as it would be comparing two different purchase numbers. However, the net impact of the shift can be seen by looking at the net losses and net gains, this is calculated in table 11.
Table 12; Changes resulting from Division B. purchases
Change
Loss/gain per unit
Net change
-500
-40,0000
1,000
10,0000
Total
-30,0000
The firm would loss contribution of 40,000 on the lost internal orders, and the division would only gain 10,000, leaving a net loss of 300,000.
The total impact is shown in table 12.
Table 13, Total change
Net change for division A
-250,000
Net change for division B
-30,0000
Net cost to firm
-280,000
Decision
The figures indicate that both departments there may be some benefits to divisional budget by moving their purchases, as their department costs per unit would decrease. However, the benefit to the firm of the in-house manufacturing of parts 101 and 201 are the gross profits that are generated and shown as contributions in this report. The losses made by the form as a result of the production being shifted out of houses is much greater than the gains being made by each department, as shown in tables 10, 11, and 12.
Discussion
The way in which transfer pricing is determined can have a significant impact on the departments' decisions. Pricing may be undertaken as cost plus mark up, at the market value, or at prices that are negotiated internally.
The current system appears t be a cost plus market up, which is resulting in a cost that is higher than market prices. If this is the result it may be argued as disadvantageous, as the internal divisions may want to look for other, lower cost suppliers, as they will show a higher cost that is necessary,. The opposite it also true, if the price was less than market price, the division selling the goods would effectively be subsiding the divisions' profits.
The market price would expose both departments to market forces and would allow the budgets to behave competitively; this would also prevent the divisions looking to the outside suppliers, which may have a new cost to the firm when there are internal benefits associated with the contributions that are generated.…
