Question

WBG manufactures and sells electronic transducers that are used in military and commercial products. WBG has three divisions: Transducer Division. Military Division, and Commercial Division. The Transducer Division designs and produces transducers that are sold externally as well as internally to the Military Division and the Commercial Division. Both the Military Division and the Commercial Division incorporate transducers in their final products that are sold to non- WBG end users. Because of the unique proprietary design of the WBG transducers. Military and Commercial Divisions only use WBG transducers in their products. All of WBG's sales are in the United States.

The three divisions are profit centers and about 50 percent of the Transducer Division output is sold externally, while the remainder is sold internally to the Military Division and the Commercial Division. WBG currently uses a full-cost transfer pricing policy for the transducers. The senior managers of the three divisions receive about 40 percent of their compensation tied to the performance of their division and the balance is received as base salary.

Because of the incessant bickering among WBG's three divisions' management teams over its current transfer pricing policy, the CEO of WBG attended a seminar on transfer pricing. After attending the seminar, the CEO proposed the following new policy for transducers: “Each month the transfer price of transducers will be the same as the external market price the Transducer Division receives for transducers sold to external customers, if. and only if. the Transducer Division is at capacity for the month. Otherwise, the transfer price is the Transducer Division's variable cost for the month.”

Required:

You work for the CEO. Write a memo to the CEO that (a) explains the benefits of the proposed policy, (b) explains the likely changes in behavior among the three divisions that the new policy is likely to produce, and (c) states what additional data the CEO and you should collect and how you would analyze the data before making a decision regarding whether or not the new transfer pricing policy should be adopted.

Answer 1

(a) Proposed policy provides transfer price equal to external market price upto the capacity of Transducer Division. Policy would create maximum profit to WBG as overall entity. Each of division can concentrate on their production without price war between the manager. Transducer division would get recovered its fixed cost and get required contribution by selling at the rate equals to external market. Over and above capacity Transducer division would incurred only variable cost that can be recovered throuh sales price.

(b) Transducer division would produce at maximum upto capacity and may not want to produce more then capacity due to non earning of any contribution over capacity production. Other division would try to buy more and more to get product at variable cost only to maximise their profit.

(c) CEO should Collects following information as well:

1. Total capacity of Transducer division and production capacity without additional Fixed cost. If increase in production result in increase in fixed cost then transfer price should include recovery of fixed cost too.

2. Sales cost incurred by Transducer division which may be eliminated during intercompany sale.

3. Buying price for Military division and commercial division if they can buy from outside market.