Module 5 Case: Accounting for Decision and Transfer Pricing 1

Trident University

Jenny.Jaboninniss@my.trident.edu

Module 5 Case: Accounting for Decision and Transfer Pricing

ACC501

Dr. Ralph Ezelle

Submitted on: March 17, 2013

 Module 5 Case: Accounting for Decision and Transfer Pricing 2

Abstract

The use of transfer prices allows company to generate separate profit figures for each

division and to evaluate the performance of each division separately. In a recent dispute

for Coffee Maker's Incorporated (CMI), one must calculate the increase or decrease in

profits for three divisions. Additionally, an explanation of the conditions to assemble a

new proposal based on the computations for Division A, B, and C.

 Module 5 Case: Accounting for Decision and Transfer Pricing 3

Managerial Accounting - Transfer Pricing

In managerial accounting, when different divisions of a multi-entity company are

in charge of their own profits, they are also responsible for their own "Return on Invested

Capital". When divisions are required to transact with each other, a transfer price is used

to determine costs (Investopedia, 2013). The essential feature of decentralization in large

firms is the creation of responsibility centers (e.g. cost, profit, or investment centers).

EVA is financial performance of these responsibility centers is evaluated on the basis of

various accounting numbers, such as standard and actual cost, divisional profit or return

on investment (EVA, 2013). A central role of the management accounting system

therefore is to evaluate (i.e. attach a dollar figure to) the transactions between the

different responsibility centers. Under the subject cost allocation one studied alternative

methods to charge user departments for the services rendered by service departments

(frequently cost centers).

Transfer prices are used to evaluate the goods and services exchanged between

profit centers (divisions) of a decentralized firm. Hence, the transfer price is the price

that the division of a company charges another division of the same company for a

product transferred between the two divisions. In this case 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 steady for several years. Recently, outside

suppliers have lessened their prices, but Division C is not lowering its prices. In addition,

all division managers are feeling the weight to increase profit. Managers of divisions A

and B would like the flexibility to purchase the parts they need from external parties to
 Module 5 Case: Accounting for Decision and Transfer Pricing 4

lower cost and increase profitability.

 Module 5 Case: Accounting for Decision and Transfer Pricing 5

Computations of the A, B, C Divisions

Division C Data
2013 in Profit
Change 2013 Proposed
Cost Lost
Division A
Part DM DL VOH TP AnVol $900,000
Unit Unit Profit Total Profit Vol Profit Profit
Division B $950,000
101 $200 $200 $300 $1,000 3000 $700 $300 $900,000 2000 $600,000 $300,000
Division C ($700,000)
201 $300 $300 $600 $2,000 1000 $1,200 $800 $800,000 500 $400,000 $400,000
Total Company $1,150,000
$1,700,000 $1,000,000 $700,000

UT.
101 201 Outside Req. Cost Outside $ Profit
Current A 3000 1000 4000 $900 $900,000
B 1000 1000 2000 $1,900 $1,900,000
C 3000 1000 4000
Proposed A 2000 2000 4000 $1,800,000 $900,000
B 500 1500 2000 $2,850,000 $950,000
C 2000 500 2500
 Module 5 Case: Accounting for Decision and Transfer Pricing 6

Analysis of Computations

Depending on the production capacity and the market for each divisions goods or

services, a transfer price could be based on cost, market prices, or some other amount

(Accounting Tools, 2013). Given that one have the operating costs of Division C, one can

calculate their loss from reduced output. In the case of Division A and Division B, the

reduction in cost related to lower outside cost would be considered profit change. The

proposal increases profit, but leaves Division C under-utilized. The fixed cost of under

utilization would have to be considered before one would suggest Coffee Maker's

Incorporated go to the new proposal. One recommends to go ahead with the new proposal

and increase Division C output and sell to outside customers.

Evaluate Transfer Pricing Policies

Transfer pricing policies should include a fixed cost portion of the internal

supplier to identify the true cost (Accounting Tools, 2013). A concern of transfer pricing

is whether the amount of the transfer price will cause a divisional manager to take action

that is not consistent with the action that is best for the company as a whole. Profit taken

by the internal supplier is overall company profit. By using a standard costing process,

the internal supplier would be expected to keep efficiency at standard. In this case.

Division C had profit from part 101 at $300 per unit and part 201 at $800 per unit. If the

fixed cost of Division C were included in the transfer price, it would not be necessary to

identify a profit per part.

Transfer price = cost plus a mark-up for the selling division. This policy provides

contribution to the cost of the selling division. The mark up must be fitting to
 Module 5 Case: Accounting for Decision and Transfer Pricing 7

abolish the cost of the selling department, but not to make the selling department

a high profit center.

Transfer price = fair market value. This policy will force profit to be declared

within the selling division and may or may not provide a means of tracking

productivity. If the fair market value produces a lot of profit for the company this

should be used.

Transfer price = price negotiated by the managers. This is a policy that can create

challenging and meaningful relationships between departments. Since the price is

negotiated, the outcome would be beneficial for the company and would

encourage competition between divisions. Although the ending price should be

less than fair market value.

Transfer Pricing for Financial and Managerial Perspective

From a financial perspective, transfer pricing can help improve profits and allows

the company more control of quality which would improve profits. It does cause

additional financial reporting for the selling division. From a managerial perspective

transfer pricing can create a competitive environment within the company resulting in

lower cost and higher profit (Investopedia, 2013). At the same it can cause complications

if one department is making more profit than another, unless it is clearly identified as

efficiency modification. In managerial accounting, when different divisions of a multi-

entity company are in charge of their own profits, they are also a responsible for their

own "Return on Invested Capital". Consequently, when divisions are required to transact

with each other, a transfer price is used to determine costs. Transfer prices tend not to

disagree much from the price in the market because one of the entities in such a
 Module 5 Case: Accounting for Decision and Transfer Pricing 8

transaction will lose out: they will either be buying for more than the existing market

price or selling below the market price, and this will affect their performance.
 Module 5 Case: Accounting for Decision and Transfer Pricing 9

Reference

Accounting Tools. (2013). Transfer pricing. Retrieved from

http://www.accountingtools.com/transfer-pricing

Value Based Management.net. (n.d.). Economic Value Added (EVA). Retrieved

fromhttp://www.valuebasedmanagement.net/methods_eva.html

Investopedia.com. (2013). Transfer Price. Retrieved from

http://www.investopedia.com/terms/t/transferprice.asp#axzz2N4CWBPen

Dear Jenny,

The case study for Module 5 provides information concerning a dispute between

divisions in the Coffeemaker International. Information was provided

concerning fixed and variable costs, production and transfer prices.

Requested was the calculation of decreases or increases in profits for the

three divisions and the company with comments and suggestions regarding

the situation. Also requested was the evaluation and discussion of four types

of transfer pricing policies.

Although your discussion is very nice, I believe there are several changes which will

have to be considered for each division as well as the corporation as a whole.

Your discussion concerning transfer pricing policies and the view from the

managerial aqnd financial perspective is excellent.

 Module 5 Case: Accounting for Decision and Transfer Pricing 10

If you will copy, paste, and go to the following URL in your web browser, I give a

brief explanation of Case 5.

http://www.screencast.com/t/eJA0R7JCp8

Current Scenario

Lets look at the problem with Coffeemaker International. First we will look at the

current purchases by Divisions A and B. Division A purchases 3,000 units of

part 101 from Division C and 1,000 units of part 101 from outside vendors.

Division B purchases 1,000 units of part 102 from Division C and 1,000 units

of part 102 from outside vendors.

Under the current purchase agreement, Division A purchases the 3,000 units of part

101 from Division C at a cost of $1,000 per unit for a total cost of $3,000,000

(3,000 units x $1,000 per unit). Division A acquires an additional 1,000 units

of part 101 from outside vendors at a cost of $900 per unit for a total cost of

$900,000 (1,000 units x $900 per unit). Division A spends a total of $3,900,000

for part 101 ($3,000,000 + $900,000). Division B purchases the 1,000 units of

part 201 from Division C at a cost of $2,000 per unit for a total cost of

$2,000,000 (1,000 units x $2,000 per unit). Division B acquires an additional

1,000 units of part 201 from outside vendors at a cost of $1,900 per unit for a
 Module 5 Case: Accounting for Decision and Transfer Pricing 11

total cost of $1,900,000 (1,000 units x $1,900 per unit). Division B spends a

total of $3,900,000 for part 201 ($2,000,000 + $1,900,000). Overall, Division C

has sales of $5,000,000 ($3,000,000 + $2,000,000) to Divisions A and B.

Divisions A and B are acquiring parts in the open market at a total cost of

$2,800,000 ($900,000 + $1,900,000).

Now lets take a look at the contribution margin of Division C under the current

scenario. Considering part 101 first, the transfer price is $1,000. If we

subtract the variable cost of $700 from the $1,000 transfer price the resultant

contribution margin is $300. With the selling of 3,000 units to Division A at

$300 per unit, the total contribution margin is $900,000. With respect to part

201, the transfer price is $2,000. If the $1,200 variable cost is subtracted from

the $2,000 transfer price, the contribution margin for part 201 is $800.

Division C sells 1,000 units to Division B so, the $800 contribution margin

times the 1,000 units of part 201 yields a total contribution margin of

$800,000. The sum of the contribution margin for part 101 and part 201 for

Division C is $1,700,000 ($900,000 + $800,000).

Proposed Scenario

The managers of the Divisions have met and are considering a new scenario where

Division A purchases 2,000 units of part 101 from Division C and 2,000 units

of part 101 from outside vendors. And, Division B purchases 500 units of part
 Module 5 Case: Accounting for Decision and Transfer Pricing 12

201 from Division C and 1,500 units of part 201 from outside vendors.

Under the proposed purchase agreement, Division A purchases the 2,000 units of

part 101 from Division C at a cost of $900 per unit for a total cost of

$1,800,000 (2,000 units x $900 per unit). Division A acquires an additional

2,000 units of part 101 from outside vendors at a cost of $900 per unit for a

total cost of $1,800,000 (2,000 units x $900 per unit). Division A spends a total

of $3,600,000 for part 101 ($1,800,000 + $1,800,000). Division B purchases

the 500 units of part 201 from Division C at a cost of $1,900 per unit for a

total cost of $950,000 (500 units x $1,900 per unit). Division B acquires an

additional 1,500 units of part 201 from outside vendors at a cost of $1,900 per

unit for a total cost of $2,850,000 (1,500 units x $1,900 per unit). Division B

spends a total of $3,800,000 for part 201 ($950,000 + $2,850,000). Overall,

Division C has sales of $2,750,000 ($1,800,000 + $950,000) to Divisions A and

B. Divisions A and B are acquiring parts in the open market at a total cost of

$4,650,000 ($1,800,000 + $2,850,000).

Lets take a look at the contribution margin of Division C under the proposed

scenario. Considering part 101 first, the transfer price is $900. If we subtract

the variable cost of $700 from the $900 transfer price the resultant

contribution margin is $200. With the selling of 2,000 units to Division A at

$200 per unit, the total contribution margin is $400,000. With respect to part

201, the transfer price is $1,900. If the $1,200 variable cost is subtracted from
 Module 5 Case: Accounting for Decision and Transfer Pricing 13

the $1,900 transfer price, the contribution margin for part 201 is $700.

Division C sells 500 units to Division B so, the $700 contribution margin

times the 500 units of part 201 yields a total contribution margin of $350,000.

The sum of the contribution margin for part 101 and part 201 for Division C

is $750,000 ($400,000 + $350,000).

Contrast

Division A has a current cost for part 101 of $3,900,000 however, under the proposed

scenario the costs will be $3,600,000 which equates to a $300,000 savings.

Division B has a current cost for part 201 of $3,900,000 but, under the

proposed scenario the costs will be $3,800,000, equating to a savings of

$100,000. Reviewing Division C, the current contribution margin is

$1,700,000 with the proposed contribution margin result being $750,000, a

reduction in the contribution margin of $950,000.

From a corporate perspective the effect is composed the savings of Division A and

Division B and the change in Division Cs contribution margin. Therefore,

Division A savings of $300,000 plus the Division B savings of $100,000 plus

the change in Division C contribution margin of ($950,000) when summed is

($550,000). Note, the parenthesis denote negative values.

Again, your discussion material is outstanding however, several adjustments will

 Module 5 Case: Accounting for Decision and Transfer Pricing 14

have to be made to account for the transfer pricing as indicated above. If you

have any questions, please let me know.

Kind Regards,

R. Wayne Ezelle, Jr., PhD