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

Exercise 31

Transfer Pricing: Performance Evaluation Issues

Cochise Corporation’s Southern Division is operating at capacity. It has been asked by Northern Division to supply it a thermal switch, which Southern sells to its regular customers for $60 each. Northern, which is operating at 70 percent capacity, is willing to pay $40 each for the switch.

Northern will put the switch into a kitchen appliance that it is manufacturing on a cost-plus basis for the Army. Southern has a $34 variable cost of producing the switch. The cost of the kitchen appliance as built by Northern follows:

Purchased parts—outside vendors	$180
Southern thermal switch	40
Other variable costs	112
Fixed overhead and administration	64
Total cost	$396

Northern believes that the price concession is necessary to get the job.

The company uses ROI and dollar profits in evaluating the division and divisional manager’s performance.

Required

a. If you were Southern’s division controller, would you recommend supplying the switch to Northern? (Ignore any income tax issues.) Why or why not?

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b. Would it be to the short-run economic advantage of Cochise Corporation for Southern to supply Northern with the switch at $40 each? (Ignore any income tax issues.) Explain your answer.

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c. Discuss the organizational and managerial behavior difficulties, if any, inherent in this situation. As Cochise’s controller, what would you advise the corporation’s president to do in this situation?

Step 1 of 4

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.