Transfer pricing strategy at Coffee Makers Incorporated

Management Accounting

Coffee Makers Incorporated Transfer Prices Case Study

The Current Position

Department B

Proposed Changes

Department B

Coffee Makers Incorporated has two divisions which purchase parts internally form a third department. Two parts; 101 and 201 are produced internally. The current transfer price for those parts is $1,000 and $2,000 respectively. The departments which are buying the parts; dept. A is buying part 101 and dep. B is buying part 201, want to change the purchase pattern, as external suppliers can supply the parts at a price less than the transfer price (dept. C) is charging.

Currently Dept A buys 3000 of the 101 parts from department C. topped up with 1,000 parts from external suppliers, department B. purchases 1,000 parts from dept. C and 1,000 parts from external suppliers. Both departments want to make a change to reduce their own costs, moving more purchases to the external supplier. It is likely that they are assuming the lower cost to the department will benefit the firm. However, the transfer price is not a price at cost; it is a price in which there is a surplus of revenues after the variable costs have been deducted. To assess if the plan to purchase more parts from external suppliers would be beneficial to the firm it is necessary to look a both the savings that will be made by the purchasing departments and the level of contribution that would be lost by department C (Atkinson et al., 2011)

Department B

The same process may be used to calculate the current net cost. Table 5 shows the costs that are incurred by dept. B under the current purchase arrangements

Table 5; Current costs to dept. B

Purchase source

Units purchased

Cost per unit

Total costs

Dept C

1,000

2,000

2,000,000

External supplier

1,000

1,900

1,900,000

Total

2,000

3,900,000

The next stage is to assess the contribution that is created for dept C. As a result of the transaction. This is shown in table 6.

Table 6; Current contribution generated on sales to dept. B

No of units purchased

Contribution per unit generated

Total contribution

1,000

800,000

With the impact on both departments calculated, they can be brought together in order to assess the net cost of the purchases to the firm, this is shown in table 7.

Table 7; Current net cost to the firm for dept. B

Costs for department A

3,900,000

Less contribution from dept. C

800,000

Net cost to firm

3,100,000

Proposed Changes

With the current net costs to the firm assessed, the next stage is to assess the costs that would be incurred if the changes were implemented. This can then be used to compare to the current costs. Each department will be considered in turn.

Department A

Dept. A wants to changes the purchases, so 200 units are purchased internally and 200 externally, table 8 shows the new costs for dept. A.

Table 8; New costs for dept. A

Purchase source

Units purchased

Cost per unit

Total costs

Dept C

2,000

1,000

2,000,000

External supplier

2,000

1,800,000

Total

4,000

3,800,000

The costs will decrease for dept. A, under this plan. However, as the number of units purchased internally decreases, the level of contribution generated will also decrease; the new contribution level is shown in table 9.

Table 9; New contribution level for dept A purchases

No of units purchased

Contribution per unit generated

Total contribution

2,000

600,000

The contribution has decreased. Bringing the change in cost and the change in contribution together the net cost of the purchases to the firm can be assessed.

Table 10; Proposed net cost to the firm for dept. A

Costs for department A

3,800,000

Less contribution from dept c

600,000

Net cost to firm

3,200,000

Department B

The new cost for department B, if they move so 500 units are purchased internally and 1,500 are purchased from external suppliers is shown in table 11.

Table 11; New costs for dept. B

Purchase source

Units purchased

Cost per unit

Total costs

Dept C

2,000

1,000,000

External supplier

1,500

1,900

2,850,000

Total

2,000

3,850,000

Again, the total costs to the department have reduced, but there is also a change in the contribution level, this is calculated in table 12.

Table 12; New contribution level for dept B. purchases

No of units purchased

Contribution per unit generated

Total contribution

400,000

Bringing together the changes the net cost to the firm can be assessed, this is shown in table 13.

Table 13; Proposed net cost to the firm for dept. B

Costs for department A

3,850,000

Less contribution from dept c

400,000

Net cost to firm

3,450,000

Findings and Discussion

Findings

To assess which option is best for the firm, the costs associated wit the current approach and the proposed approach can be assessed to determine if the firm will be better off with a change. The costs for both firms for the current and the proposed change are presented in table 12.

Table 14; Comparison of the current and proposed purchase strategy

Dept. A

Dept. B

Current net cost

3,000,000

3,100,000

Proposed change net cost

3,200,000

3,450,000

Net benefit/loss

-200,000

-350,000

It is apparent from the assessment, that there would be a negative impact on the firm if the departments were to shift purchases so more were obtained from external suppliers. This may not appear logical to the departments as they will be paying more, but it will mean more money is retained within the firm. The cost savings made by departments buying from the outside supplies are less than the contribution that is lost.

Discussion

The issue with the departments is the price that is charged by dept. C as a cost plus mark up that has not been reviewed. The market prices have fallen, and the departments will have their own budgets; while they pay a higher than market price for the units they have higher costs then they may want. It could be argued that the situations may be resolved by dept C. adjusting its prices to match the market prices, there will be less contribution, but the net cost to the firm will remain the same and departments A and B. will be happy. The problem may occur if dept. C is a profit center, as this will reduce their profit (Libby et al., 2010).

The issue of transfer pricing is significant from a managed and financial perspective as it determines what many comes from where, how it is spent and how it is earned; impacting significantly o the departmental or business unit budgets (Libby et al., 2010). This may also have a knock on effect in the way department costs are managed, if there is no pressure to reduce costs as the transfer prices are supporting the supplying department, they may not look for savings to reduce their costs and potential efficiencies may go unrecognized. Conversely, departments that are paying high costs may appear to be inefficient. The impact ion the bottom line may not have a direct impact, but it will impact on the way management decisions are made.