accounting pricing

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Two divisions of a company 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 constant for several years.

Recently, outside suppliers have lowered their prices, but C Division is not lowering its prices. In addition, all division managers are feeling the pressure to increase profit. Managers of Divisions A and B would like the flexibility to purchase the parts they need from external parties to lower cost and increase profitability.

The current pattern is that Division A purchases 3,000 units of product part 101 from Division C (the supplying division) and another 1,000 units from an external supplier.  The market price for part 101 is $900 per unit. Division B purchases 1,000 units of part 201 from Division C and another 1,000 units from an external supplier. Note that both divisions A and B purchase the needed supplies from both the internal source and an external source at the same time.

The mangers for Divisions A and B are preparing a new proposal for consideration.

  • Division C will continue to produce parts 101 and 201. All of its production will be sold to Divisions A and B. No other customers are likely to found for these products in the short term given that supply is greater than demand in the market.
  • Division C will manufacture 2,000 units of part 101 for the Division A and 500 units of part 201 for the Division B.
  • Division A will buy 2,000 units of part 101 from Division C and 2,000 units from an external supplier at $900 per unit.
  • Division B will buy 500 units of part 201 from Division C and 1,500 units from an external supplier at $1,900 per unit. 

Division  C Data 2012 Based on the Current Agreement

Part

101

201

Direct materials

$200

$300

Direct labor

$200

$300

Variable overhead

$300

$600

Transfer price

$1,000

$2,000

Annual Volume

3,000 units

1,000 units

 

Required:

  • Calculate the increase or decrease in profits for the three divisions and the company as a whole (four separate computations) if the agreement is enforced. Explain your thought process, comment on the situation, and make a suggestion based on the computations you have made.
  • Evaluate and discuss the implications of the following transfer pricing policies:
    • Transfer price = cost plus a mark-up for the selling division
    • Transfer price = fair market value
    • Transfer price = price negotiated by the managers
  • Why is transfer pricing such a significant issue both from a financial and managerial perspective? 

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