Question

BOR CPAs, Inc. is a closely held corporation owned by three stockholders who used the initials of their last names to form the corporation’s name: Cyrus Bailey, John Ogden, and Samuel Rogers. The firm’s Certified Public Accountants (CPAs) perform audits of both public companies and privately owned companies. BOR’s CPAs also provide tax services to both individuals and businesses.

The corporation is divided into two profit centers: the Audit Division and the Tax Division. Each division is composed of two cost centers. The Audit Division is composed of two cost-center departments: Public Company Audits and Private Company Audits. The Tax Division is composed of two cost-center departments also: Individual Tax and Business Tax.

BOR, a decentralized organization, is interested in evaluating the performance of the two divisions. The stockholders are responsible for deciding on investment in the two divisions. Cyrus Bailey is in charge of the performance evaluation, and turns to you for assistance. Mr. Bailey is only interested in evaluating operations at the profit center (division) level, and not at the cost center (department) level.

Mr. Bailey is considering temporarily using some of the staff from the Tax Division to assist the Audit Division during the upcoming busy audit season, and would like to evaluate the effect of this on net income. The Tax Division is estimated to have 800 hours of excess capacity.

The unit for determining sales revenue in both divisions is the "engagement", which means the total agreed-upon work for a given client in either audit or tax for a given year. The company charges on average a fee of $75,000 per audit engagement, and $15,750 per tax engagement.

The company has its own Payroll Office, which provides payroll services to both divisions and will allocate its total expenses to the two divisions as service department charges.

The following chart shows some basic data for the company:

Hourly market rate for staff (the price the company would have to pay from an outside contractor for staff services)	$110.00
Average hourly cost rate for staff (the average price the company pays to its staff)	$50.00
Number of paychecks issued by Audit Division	110
Number of paychecks issued by Tax Division	340
Total expense for Payroll Office	$29,250
Amount of assets invested in Audit Division by BOR CPAs, Inc.	$10,000,000
Amount of assets invested in Tax Division by BOR CPAs, Inc.	$4,000,000

Given that Mr. Bailey is evaluating BOR CPAs, Inc., which is an investment center, what transfer pricing option(s) would he most prefer that the divisions use? Check all that apply.

No transfer between divisions

Market transfer price of $110.00 per hour

Variable standard cost transfer price of $50.00 per hour

Negotiated transfer price of $80.00 per hour

2. Which transfer pricing option(s) would the manager of the Audit Division prefer? Check all that apply.

Variable standard cost transfer price of $50.00 per hour

Market transfer price of $110.00 per hour

No transfer between divisions

Negotiated transfer price of $80.00 per hour

3. Which transfer pricing option(s) would the manager of the Tax Division prefer? Check all that apply.

Market transfer price of $110.00 per hour

Negotiated transfer price of $80.00 per hour

No transfer between divisions

Variable standard cost transfer price of $50.00 per hour

4. Given the preferences of the managers of the Audit and Tax Divisions, and also considering the preferences of BOR CPAs, Inc., what might be the decision that provides the best outcome for all levels and entities within the company?

The company should use the market transfer price, since it’s important for the divisions to operate under real market conditions.

If the divisional managers cannot come to an agreement, it’s best to forgo any transfers between divisions in order to reduce conflict within the company.

Use the negotiated transfer price, so that each entity is better off than it would be without any transfers between divisions.

The company should use the variable standard cost transfer price, because it would be unfair for the Tax Division to make a profit in dealing with the Audit Division, since they’re in the same company.

Answer 1

Solution 1:

Mr. Bailey would prefer departments using the following option:

Market transfer price of USD 110 per hour, as this would correctly reflect the picture of operations of both the divisions, if they were to operate independently under open market conditions.

Solution 2:

The audit manager would prefer either a variable cost transfer price of USD 50 as the first preference. As he is buying resources, this would minimize his cost.

As a second preference, he may agree for negotiated transfer price of USD 80.

At a transfer price of USD 110, he would be indifferent to taking resources from tax or outside contractor.

Solution 3:

The tax division manager would seek to maximise the profit from use of his resources, and would therefore, ideally prefer a market price of USD 110 per hour.

However, if there is additional capacity in terms of manhour, he may agree for USD 80 per hour rate also, as this helps him not only recover salary cost but also make an element of profit.

Solution 4:

For best outcome to the company, the divisions should use a negotiated transfer price. This will have the following benefits:

• Utilisation of capacity within the organisation.
• From an entity perspective, there is not outflow of funds and associated costs with utilisation internal staff
• The negotiated price in a way, saves some cost for the audit department (they pay USD 80 to tax department, instead of USD 110 to external party) and also ensure tax department earns a reasonable margin over their staff costs (USd 80 earnings against USD 50 staff costs, hourly)

Therefore, from an organisational perspective, this becomes a win win situation