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

Exercise 32

Evaluate Transfer Price System

Western States Supply, Inc. (WSS), consists of three divisions—California, Northwest, and Southwest—that operate as if they were independent companies. Each division has its own sales force and production facilities. Each division manager is responsible for sales, cost of operations, acquisition and financing of divisional assets, and working capital management. WSS corporate management evaluates the performance of each division and its managers on the basis of ROI.

Southwest has just been awarded a contract for a product that uses a component manufactured by outside suppliers as well as by Northwest, which is operating well below capacity. Southwest used a cost figure of $37 for the component in preparing its bid for the new product. Northwest supplied this cost figure in response to Southwest’s request for the average variable cost of the component; it represents the standard variable manufacturing cost and variable marketing costs.

Northwest’s regular selling price for the component that Southwest needs is $65. Northwest’s management indicated that it could supply Southwest the required quantities of the component at the regular selling price less variable selling and distribution expenses. Southwest management responded by offering to pay standard variable manufacturing cost plus 25 percent.

The two divisions have been unable to agree on a transfer price. Corporate management has never established a transfer price policy. The corporate controller suggested a price equal to the standard full manufacturing cost (that is, no selling and distribution expenses) plus a 20 percent markup. The two division managers rejected this price because each considered it grossly unfair. The unit cost structure for the Northwest component and the suggested prices follow.

Costs
Standard variable manufacturing cost	$32
Standard fixed manufacturing cost	13
Variable selling and distribution expenses	5
Total cost	$50
Alternative transfer prices
Regular selling price	$65
Regular selling price less variable selling and distribution expenses ($65?$5)	$60
Variable manufacturing plus 25% ($32 × 1.25)	$40
Standard full manufacturing cost plus 20% ($45 × 1.20)	$54

Required

a. Discuss the effect that each of the proposed prices could have on the attitude of Northwest’s management toward intracompany business.

---

b. Is the negotiation of a price between Northwest and Southwest a satisfactory method to solve the transfer price problem? Explain your answer.

---

c. Should WSS’s corporate management become involved in this transfer price controversy? Explain your answer.

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.