Coffee Maker’s Incorporated: Transfer Pricing

Summary of data for division A and B

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Division Type of unit bought Market price per unit Units bought from Division C Units bought from an external source Total number of units Transfer price
A 101 $900 3000 1500 4500 $1,000
B 201 $1900 1000 500 1500 $2,000

The table presented below gives the current arrangement for division C.

Part 101 201
Direct material $200 $300
Direct labor $200 $300
Variable overhead $300 $600
Transfer price $1000 $2000
Annual volume 3,000 units 1000 units

The tables presented below shows the computations of the increase or decrease in profit for the three divisions.

Division A

Current state

Purchase (from division C) 3,000 * $1,000 3,000,000
Purchase (from external supplier) 1,500 * $900 1,350,000
Total cost $4,350,000

After the proposal

Purchase (from division C) 2,000 * $1,000 2,000,000
Purchase (from external supplier) 2,000 * $900 1,800,000
Total cost $3,800,000

Division B

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Current state

Purchase (from division C) 1,000 * $2,000 2,000,000
Purchase (from external supplier) 500 * $1,900 950,000
Total cost $2,950,000

After the proposal

Purchase (from division C) 500 * $2,000 1,000,000
Purchase from external supplier 1,500 * $1,900 2,850,000
Total cost $3,850,000

Division C

Current state

The calculations are based on the assumption that the values of direct material, direct labor, and variable overhead provided are per-unit costs.

Amount in $ Amount in $
Sales
101 3,000,000
201 2,000,000
Total sales 5,000,000
Costs of goods sold
Direct materials
101 600,000
201 300,000
Direct Labour
101 600,000
201 300,000
Variable overhead
101 900,000
201 600,000 3,300,000
Profit 1,700,000

After the proposal

Amount in $ Amount in $
Sales
101 2,000,000
201 1,000,000
Total sales 3,000,000
Costs of goods sold
Direct materials
101 400,000
201 150,000
Direct Labour
101 400,000
201 150,000
Variable overhead
101 600,000
201 300,000 2,000,000
Profit 1,000,000

Summary of calculations

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Division Before the proposal After proposal Increase / (decrease) in profit
Amount Units Amount Units
A 4,350,000 4500 3,800,000 4000 $550,000
B 2,950,000 1500 3,850,000 2000 ($900,000)
C 1,700,000 4000 1,000,000 2500 ($700,000)
Total change in profit for the whole company ($1,050,000)

Discussion

The calculations above show that the total cost of sales for division A before the proposal was $4,350,000. After the implementation of the proposal, the total cost was reduced to $3,800,000. A reduction in cost translates to an increase in profit of $550,000. It can also be noted that the number of units purchased by the division reduced by 500 after the implementation of the proposal. In the case of division B, the total cost increased from $2,950,000 to $3,850,000. An increase in cost contributes to a decline a profit. Therefore, profit will fall by $900,000. Also, the number of units purchased increased by 500. Finally, for division C, profit decreased from $1,700,000 to $1,000,000. The decrease amounts to $700,000. The changes in the three divisions result in a decrease in profit of $1,050,000 for the whole company.

In the example above, it can be noted that there were diverse intentions in the different divisions. It is evident that the divisions were under pressure to improve their margins. Division A and B manufactures goods and sell them to external consumers. However, division C targets internal customers. Further, the proposals indicate that the managers focus on improving the bottom line of their divisions. This resulted in a loss for the whole company because the divisions focused on their own goals more than those of the whole company. The scenario in the case of Coffee Maker’s Incorporated presents one problem that arises as a result of transfer pricing. Apart from the decline in profit, it can also be noted that there was a significant decline in the units produced by division C. Analyzing the performance of division C should go beyond the transfer prices and the costs.

One important factor that should be taken into account when coming up with transfer prices is the fixed costs. These costs are incurred by all the divisions. Another factor is the prevailing market price for the products that are manufactured by division C. In this example, it can be noted that the market prices for product 101 and 201 are lower than the price charged by division C. It is prudent for the other two divisions to purchase from Division C irrespective of the difference in the prices. The decision to purchase product 101 and 201 from an external source should be based on the comparison between the variable cost of producing the two components internally and the market price. If the variable cost of producing the commodity is less than the market price, then all goods produced internally should be purchased. However, if the production of division C cannot satisfy the requirements of the other two divisions, then it is advisable to buy the commodities from other available sources. Another factor to consider is hidden costs that arise from the purchase of goods from external sources. Another factor is cash handling costs. This arises when commodities are bought using cash. From a global point of view, a reduction in production is not good for the entire economy. It results in a reduction in supply and loss of employment. This may in turn lead to a loss of consumer purchasing power. If a company decided to make use of a transfer pricing policy, then it is important for the various units to ensure that their goals are in the best interest of the whole organization (Walther, 2012).

Transfer pricing policies

Transfer price = cost plus mark-up for the selling division

If the transfer price is inclusive of the markup, then the management of Division C will lack the motivation to manage the costs for the internal customers. Thus, the management will overlook the internal customers and focus their attention on profit and external customers. It is worth pointing out that Division A and B will only purchase from Division C if it focuses on cost reduction rather than profit maximization (King, 2008).

Transfer price = Fair market price

This policy appears as the most direct to implement. Besides, it appears to be most appropriate. However, there are a number of aspects that come to play before this policy is accepted. There are a number of concerns that arise when the transfer price is set equal to the market price. An example is price distortion. Some of the factors that can distort the market price are new technology and competition among other factors. Therefore, a company should consider these and other reasons before setting transfer prices equal to the market price. In this scenario, it is important to guard Division C against competition that arises from other producers. Besides, the company has a massive investment in machinery, equipment, and personnel who work in this department (King, 2008). This makes it necessary to have purchase agreements until the point where the Division can compete favorably with external markets. Another important point to take into consideration is the level of efficiency of division C. The division may be less efficient as compared to its competitors. Thus, setting transfer prices equals the market price may not be a viable option for a division producing for another division. Such productions should not be based on incentives. The management can be motivated by using incentives that are pegged on sales to an external market, not an internal market (King, 2008).

Transfer price = price negotiated by managers

In this scenario, the price is negotiated by the managers of the three divisions. When negotiating the transfer price, it is important to take into account the volume requirements of division A and B, and the cost of procurement. Also, all production of division C should be purchased internally before exploring external sources. This will have a positive impact on the bottom line and the fixed costs. Finally, when using transfer pricing, it is important to base incentives on factors other than the reduction of cost and profit maximization at the division level (King, 2008).

Significance of transfer pricing

As seen in the example of Coffee Maker’s Incorporated, transfer prices coordinate the decisions made by the management in a firm with many divisions. Some of the decisions focus on the prices, quantities produced, and staffing among other factors. Transfer prices also play a financial role through taxation and profit distribution. This occurs when profits are allocated to the divisions. Thus, an optimal transfer price for a company prompts a trade-off (Stuart, 2009).

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References

King, E. (2008). Transfer pricing and corporate taxation: problems, practical implications and proposed solutions. USA: Springer Science & Business Media.

Stuart, A. (2009). Transfer pricing: a world of pain. Web.

Walther, I. (2012). Chapter twenty-one. Budgeting: planning for success. Web.

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