Reference no: EM13376300

Two divisions of 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 constant for several years.

Recently, outside suppliers have lowered their prices, but Division C 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 managers 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 be 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?