ACC 550 Module 9 Transfer Pricing Assignment Example

Pricing Halves Inside the Company: A Transfer Price That Works in Normal Years and a Glut

[Student Name]

Southern New Hampshire University

ACC 550: Cost Accounting

Module Nine Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

Pricing Halves Inside the Company: A Transfer Price That Works in Normal Years and a Glut

Introduction

The pecan sheller's candy division makes pralines, chocolate-covered pecans and gift tins. It buys about 600,000 pounds of halves a year from the shelling operation, roughly 10 percent of the plant's halves. For years the transfer price was set at the shelling operation's allocated cost, which the candy manager liked and the plant manager resented, because the plant could have sold the same halves to outside buyers for more. With the candy division now evaluated on a scorecard that includes contribution, and the plant evaluated on its profit, the price matters to both managers' results and to the decisions they make (Datar & Rajan, 2021).

Candidate Prices

Table 1. Candidate Transfer Prices per Pound of Halves

The full cost figure is not what the plant gives up by transferring halves. Most of it is joint cost, incurred to produce halves, pieces and meal together, which does not change whether a particular pound of halves goes to candy or to an outside buyer.

The Minimum Price Rule

The general rule is that the minimum price the selling division should accept equals its incremental cost of the transfer plus its opportunity cost, the contribution it gives up by not selling outside. In a normal year, the plant can sell every pound of halves to bakeries and exporters at $9.40. Transferring a pound to candy saves $0.30 of selling cost but forgoes $9.40 of outside revenue, so the minimum price is $9.10. A transfer price of $7.28 would make the plant worse off on every pound and would effectively subsidize the candy division.

In the current glut, conditions differ. Export buyers have cut orders, the plant holds 1.2 million pounds of unsold halves in cold storage, and the few outside buyers will pay only about $8.20. Two cases apply. For halves that could be sold outside at $8.20, the minimum price is $8.20 less $0.30, or $7.90. For halves that cannot be sold outside at all this season, the opportunity cost is close to zero, and the minimum is the incremental cost of storing and handling, about $0.15 a pound.

Effects on Decisions

The candy division earns about $11.50 a pound of halves before paying for them. At any price below $11.50, buying halves internally adds to its contribution, so it will keep buying. The question is what each price does to the company.

In a normal year, the company gains $11.50 a pound when halves go to candy and $9.10 net when they go outside. Candy is the better use as long as its margin exceeds $9.10, which it does. A market-based price of $9.10 leads both managers to that result: the plant is indifferent, and the candy division still earns $2.40 a pound. A full-cost price of $7.28 leads to the same transfer but misstates performance, showing candy $1.82 a pound more profitable than it is and the plant less.

In the glut, the company gains on every pound candy uses from the unsold stock, because otherwise those halves earn nothing or deteriorate. A price of $9.10 might lead the candy manager to hold back on a new corporate gift line that would earn $8.50 a pound before halves, a decision that would be wrong for the company. A lower price for the unsold stock would encourage candy to use more halves, which is what the company wants.

Dual Pricing and Negotiation

Two alternatives were considered and set aside. Dual pricing, crediting the plant with the market price while charging candy a lower cost-based price, would make both divisions look good, but their combined reported profit would exceed the company's actual profit, a gap someone must explain each quarter; it also weakens the candy manager's incentive to use halves efficiently. Pure negotiation each season would preserve autonomy but would consume management time and could break down when the two managers disagree about market conditions, which in a volatile crop year they would. A rule-based market price with a narrow negotiated band for surplus stock keeps most of the benefits of each approach. The controller should also check each year whether any transfers are taking place at prices that would lead a manager to turn down an internal sale that benefits the company, which is the practical test of goal congruence.

Recommended Policy

The company should set the transfer price at the outside market price less avoided selling costs, adjusted each quarter, so that it reflects current conditions: about $9.10 in a normal year and $7.90 in the current glut. For volume above the candy division's normal requirement drawn from stock that cannot be sold outside this season, it should allow a negotiated price between the incremental cost and the outside price, so that new candy products using surplus halves are not discouraged. Both managers should be evaluated on contribution at the agreed price, and the controller should report the company-wide effect of transfers each quarter. Cools et al. (2008) found that firms often struggle when a single transfer price is asked to serve both management control and other purposes, which argues for keeping the internal policy simple and explicit. Labro (2019) adds that cost figures built for one purpose, such as inventory valuation, should not be reused for another without asking what they represent.

Conclusion

Allocated full cost, $7.28 a pound, does not reflect what the shelling operation gives up and should not be the transfer price. In a normal year the market-based price, $9.10, aligns both managers with company profit. In the current glut the market-based price falls to about $7.90, and surplus halves that cannot be sold outside should move at a negotiated price closer to incremental cost. A quarterly market-based policy with a surplus provision keeps decisions aligned in both conditions.

References

Cools, M., Emmanuel, C., & Jorissen, A. (2008). Management control in the transfer pricing tax compliant multinational enterprise. Accounting, Organizations and Society, 33(6), 603-628. https://doi.org/10.1016/j.aos.2007.05.004

Datar, S. M., & Rajan, M. V. (2021). Horngren's cost accounting: A managerial emphasis (17th ed.). Pearson.

Labro, E. (2019). Costing systems. Foundations and Trends in Accounting, 13(3-4), 267-404. https://doi.org/10.1561/1400000058