Transfer pricing question needs solution urgent

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reena jain (Querist)
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13 April 2016 Klein, Thompson Company’s CFO, has determined that the Motor Division has purchased switches for its motors from an outside supplier during the current year rather than buying them from the Switch Division. The Switch Division is operating at full capacity and demanded that the Motor division pay the price charged to outside customers rather than the actual full manufacturing costs as it has done in the past. The Motor Division refused to meet the price demanded by the Switch Division. The Switch Division contracted with an outside customer to sell its remaining switches and the Motor division was forced to purchase the switches from an outside supplier at an even higher price.

Klein is reviewing Thompson’s transfer pricing policy because she believes that sub-optimization has occurred. While Klein believes the Switch Division made the correct decision to maximize its divisional profit by not transferring the switches at actual full manufacturing cost, this decision was not necessarily in the best interest of Thompson.

Klein has requested that the corporate Accounting Department study alternative transfer pricing methods that would promote overall goal congruence, motivate divisional management performance, and optimize overall company performance. The three transfer pricing methods being considered are listed below. One of these methods will be selected, and will be applied uniformly across all divisions.

• Standard full manufacturing costs plus mark-up.

• Market selling price of the products being transferred.

• Costs incurred to the point of transfer plus opportunity cost per unit.

Another issue for Thompson Company is regarding its Division Z, Y, A and B, which is as follows:

Division Z of Thompson produces a component that it currently sells to outside customers for OMR 20 per unit. At its current level of production, which is 60% of capacity, Division Z’s fixed cost of producing this component is OMR 5 per unit and its variable cost is OMR 12 per unit. Division Y of Thompson Company would like to purchase this component from Division Z for OMR 10. Division Z has enough excess capacity to fill Division Y’s requirements. The managers of both divisions are compensated based upon reported profits. Recommend a price that will maximize total company profits and be most equitable to the managers of Division Y and Division Z?

Thompson Company has two sub divisions – A and B. Division B currently operates at 100% of its capacity and produces two products: Dango and Tango. Division B sells both products to outside customers for OMR 15 and OMR 30 per unit, respectively. At current production level the variable costs of Dangos are OMR 10 per unit, and fixed costs are OMR 3 per unit and for Tangos, the variable costs are OMR 16 per unit, and fixed costs are OMR 8 per unit.

Division A, which currently purchases Dangos from an outside supplier for OMR 16 per unit, would like to purchase 150 Dangos from Division B annually. However, if Division B increases the production of Dangos to meet the demand of Division A, it must stop producing Tangos entirely. Also, to meet stricter quality requirements of Division A, Division B must increase material cost by OMR 0.80 per Dango, but the marketing and transportation cost per Dango will be reduced by OMR 0.50 per unit. The total units of Tango produced and sold by Division B is 50 units per year.

Suggest the price range within which the transfer price for Dangos would satisfy both divisions i.e. Division A and Division B.

You are required to write a report to the Board of Directors of Thompson Company giving your suggestions and covering the following points:

· Introduction of Transfer Pricing, the discussion needs to be supported by relevant academic literature. (300)

· Transfer Pricing and Performance Evaluation Measures. (300)

· Detailed discussion on the different types of Transfer Pricing Methods used by Organizations. (700)

Amol S Joglekar

Amol S Joglekar (Expert)
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13 April 2016 OMR : Omani Riyal.
The dominance of the internal department in price fixation of the products which are made internally shows that they have started CROSSING their limit. The LIMIT of such a department is to manufacture/produce the products as per the specifications as to quality, quantity, time etc. The very fact that SWITCH division dared demanding a price from our internal MOTOR division indicates the belief of the said division as to having its monopoly in the said area.
All the divisions of the company must move in a well CO ORDINATED manner in order to produce the optimum profit for the company as a whole.
The transfer pricing has , thus started loosing its basic and very purpose, So I request the BOD to stop the practice henceforth and the discussion of the same be ONLY restricted with ACCOUNTs department.

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