Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 21

Evaluate Transfer Pricing System

Carmen Seville and Don Turco jointly own Bright Green Temp Services (BGTS). Carmen owns 60 percent and Don owns 40 percent. The company provides temporary clerical services at a rate of $40 per hour. During the past year, its clients used 14,000 hours of temporary services.

Big City Developers purchased 2,800 hours of temporary services from BGTS last year. Carmen has a 20 percent interest in Big City Developers, and Don has a 60 percent interest in it. At the end of the year, Don suggested that BGTS give Big City Developers a 10 percent reduction in the hourly rate charged next year in recognition of its large purchases and desirability as a client.

Required

Assuming that Big City Developers purchases the same number of hours and that all other costs and activities remain the same in the coming year, what effect would the price reduction have on BGTS’s operating profits that accrue to Carmen and to Don for the coming year?

Step 1 of 2

Transfer pricing

Transfer pricing is the amount charged by one business unit of a company to another business unit for the products supplied. Each business unit is considered as separate responsibility centers and sale from one business unit to another business unit is consider as sale to an outsider. The sales based on transfer pricing are recorded in the accounting books of a firm and transfer prices are used for decision making, merchandise costing and performance assessment.