This paper examines the transfer pricing decisions faced by Coffee Makers Incorporated (CMI), focusing on three internal divisions. Divisions A and B currently purchase components from Division C at internal transfer prices above available external market rates. The paper calculates current net costs to the firm, evaluates proposed shifts toward external suppliers, and demonstrates that while divisional budgets may improve under the new arrangements, the firm as a whole incurs a net loss due to reduced internal contributions from Division C. The analysis concludes with a discussion of alternative transfer pricing methods — cost-plus, market-based, and negotiated pricing — and their implications for divisional efficiency, profitability, and competitive behavior.
The paper demonstrates contribution margin analysis as a tool for evaluating internal transfer pricing decisions. By calculating the contribution generated by Division C on each internal sale and subtracting it from divisional purchase costs, the author derives a firm-wide net cost that reveals the true financial impact of switching to external suppliers — a figure that divisional budget comparisons alone would obscure.
The paper opens with a brief introduction framing the make-or-buy problem. It then works through a current-state analysis for each division using paired cost and contribution tables. A parallel set of tables models the proposed changes, followed by a concise decision section that interprets the net results. The paper closes with a conceptual discussion of transfer pricing methods and their behavioral effects on divisional managers.
The decision to make or purchase a good that can be, or already is, supplied internally requires careful consideration. Different departments may view the issue differently, especially when internal transfer pricing does not reflect prevailing market conditions. Although different departments may operate under separate budgets, the firm must also take a broader view and consider the impact on the overall bottom line.
In this case, Coffee Makers Incorporated (CMI) is considering the position of three divisions. Divisions A and B both purchase parts from Division C. Division A buys Part 101 at a transfer price of $1,000, and Division B buys Part 201 at a transfer price of $2,000. Both divisions are under pressure to increase their profitability. When Division A identifies the opportunity to purchase Part 101 externally for $900, and Division B finds an external supplier offering Part 201 for $1,900, both wish to shift more of their purchases externally, as doing so would improve their individual divisional profitability.
The aim of this paper is to assess the current position and then evaluate the potential impact of proposals for more of the parts to be purchased from external suppliers at the lower cost.
Before examining the individual divisions, it is useful to look at the current costs to Division C and calculate the total variable cost and the contribution (transfer price minus variable cost) for each part. The contribution represents the gross profit of the product.
Table 1: Contribution for each part for Division C
Transfer price: $1,000 (Part 101) / $2,000 (Part 201). The contribution per unit is derived by subtracting direct material, direct labor, and variable overhead from the respective transfer prices.
The next consideration is the existing position of the firm and the total net cost for each division. Division A currently purchases 3,000 units from Division C and a further 1,500 units from an external supplier.
Table 2: Current costs for Division A
Division C: 3,000 units at $1,000 = $3,000,000. External source: 1,500 units at $900 = $1,350,000. Total: 4,500 units = $4,350,000.
With 3,000 units purchased internally, the next stage is to calculate the total contribution those internal purchases generate for the firm.
Table 3: Contribution created by Division A's purchases
3,000 units purchased internally, at a contribution per unit of $300, produces a total contribution of $900,000.
The net cost to the company is determined by taking the total purchase cost and deducting the contribution earned from internal sales.
Table 4: Net cost to the firm for Division A's 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 Division B's purchases. Division B currently purchases 1,000 units from Division C and a further 500 units from an external supplier.
Table 5: Cost of Division B's purchases
Division C: 1,000 units at $2,000 = $2,000,000. External supplier: 500 units at $1,900 = $950,000. Total: 1,500 units = $2,950,000.
With 1,000 units purchased from Division C, the next step is to determine the contribution earned by Division C on those transactions.
Table 6: Contribution created by Division B's purchases
1,000 units purchased internally, at a contribution per unit of $800, produces a total contribution of $800,000.
This contribution is then 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 Division B (Table 5): $2,950,000. Less contribution from Division C (Table 6): $800,000. Net cost to firm: $2,150,000.
Under the current arrangement, the combined net cost to the firm for Parts 101 and 201 is as follows.
Table 8: Total current net costs
Net costs for Division A: $3,450,000. Net costs for Division B: $2,150,000. Total net cost: $5,600,000.
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