Assignment 3: Management Accounting Case: West Island Produc

Assignment 3: Management Accounting Case: West Island Products Due Week 8, Day 7 (100 points) 6 pages

The assignment involves analyzing a transfer pricing decision within West Island Products (WIP), a divisionalized furniture manufacturer. The focus is on determining an appropriate transfer price for cushioned seats from the Office Division to the Commercial Division, considering factors such as costs, profitability, market conditions, and internal business considerations. The case also requires evaluating in-sourcing versus out-sourcing options, understanding managerial and corporate perspectives, and proposing policies for future transfer pricing disputes.

Paper For Above instruction

In contemporary management accounting, transfer pricing is a critical issue that influences divisional performance, resource allocation, and overall corporate strategy. The West Island Products (WIP) case provides a nuanced scenario where the divisional managers must determine how to price a product (cushioned seats) transferred internally for use in a new product line, balancing divisional profitability with corporate-wide considerations. This situation exemplifies the complexities of transfer pricing, especially when divisions are autonomous, and external markets are available, making the decision more intricate.

Introduction

Transfer pricing refers to the set of rules and methods for pricing goods, services, or intangible property when they are transferred within an organization, often across divisional boundaries. The correct determination of transfer prices impacts divisional profitability, motivation, and the overall strategic alignment of a company. In the case of WIP, the question centers on how to price cushioned seats that are produced by the Office Division and transferred to the Commercial Division for a new product line.

The core challenge lies in how to balance the interests of the Office Division, aiming to maintain profitability, and the Commercial Division, which wants to minimize costs to maximize market competitiveness. The complexity increases considering capacity constraints, internal cost structures, external supplier quotes, and indirect effects such as potential shifts in product mix and market timing.

Re-examining Nathan Danielson’s Calculation of Transfer Price

Initially, Nathan Danielson proposed a transfer price based on full cost plus a 30% markup, arriving at $2,053 for 100 seats. This approach aligns with traditional cost-plus methods, ensuring the Office Division covers its costs and earns a profit margin. However, Danielson also suggests that the price could be set based on variable costs, which reflects a more short-term, contribution-based perspective.

To confirm or re-calculate an appropriate transfer price that aligns with Danielson’s objective of maintaining Office Division profitability, we should consider the division’s costs structure. From Exhibit 1, the standard costs of the cushioned seat include direct materials at $6.40, direct labor for cushion fabrication at $3.75, and manufacturing overhead allocated at $15.00, summing to a total standard cost of $25.85 per seat. For 100 units, this totals $2,585.

However, since Danielson emphasizes the variable costs, it’s necessary to identify the variables involved. Direct materials are slightly higher due to a 10% increase, and the direct labor cost remains the same. Manufacturing overhead, at $10 per direct labor hour, includes both fixed and variable components totaling $15 per unit. The variable manufacturing overhead can be isolated by summing the variable components like supplies, indirect labor, power, heat, and employee benefits, which total around $7.35 per unit. Therefore, the variable cost per seat hinges mainly on direct materials, direct labor, and variable overhead.

Calculating the variable cost per unit:

- Raw materials: Approximately $7.04 (assuming a 10% increase over the office stool's $6.40)

- Direct labor: $3.75

- Variable manufacturing overhead: approximate $7.35 - $15 total overhead, with variable portion being around half, say $7.50.

Summing these: $7.04 + $3.75 + $7.50 = approximately $18.29 per seat.

Thus, the total variable cost for 100 seats is roughly $1,829. Based on Katz’s perspective, pricing at variable cost ($18.29 per seat) results in $1,829 for 100 seats, which is lower than the Office Division’s full cost of $2,585.}")

Determining the Appropriate Transfer Price

The goal is to establish a transfer price that satisfies the objectives of both divisional autonomy and overall corporate profitability. Considering Danielson’s goal to maintain the divisional profit margin, a transfer price equal to full cost plus a markup ensures the Office Division’s profitability remains intact. Alternatively, pricing at variable cost might incentivize the Commercial Division to purchase externally if external quotes are lower but could lead to the Office Division incurring losses if internal prices are too low.

A balanced approach would be to set a transfer price within a range of variable cost and full cost plus markup, often called a transfer price corridor. This approach allows flexibility, ensuring the Office Division covers its costs and earns a profit while the Commercial Division benefits from a competitive price. If the company adopts transfer pricing based on negotiation within this range, it fosters cooperation and strategic alignment.

Pros and Cons of Each Option

In-Sourcing (Internal Transfer at Negotiated Price)

Pros:

• Ensures divisional autonomy and motivation, as each division is evaluated on its profitability.
• Encourages internal collaboration and resource sharing.
• Provides managerial control over quality and delivery standards.

Cons:

• Potential for conflict if divisions do not agree on a fair price.
• Requires ongoing negotiation and managerial oversight.
• May distort divisional performance metrics if transfer prices are manipulated.

Out-Sourcing (External Purchase at Market Price)

Pros:

• Promotes external competitiveness by encouraging divisions to source from external suppliers when cost-effective.
• Reduces internal conflict over transfer prices.
• External prices provide market-based benchmarks, aiding strategic decision-making.

Cons:

• Reduces internal control over quality, timing, and proprietary technology.
• May lead to loss of internal capabilities and future flexibility.
• Impacts division performance metrics negatively if external prices are higher or lower than internal costs.

Likely Recommendations from the Corporate Controller

The corporate controller would likely favor transfer prices that promote overall profitability and clarity, perhaps advocating for a cost-based approach with an acceptable range for negotiation. They may prefer to establish a transfer price at the midpoint between variable cost and full cost with markup, aligning with principles of fairness and internal discipline. The controller may also emphasize the importance of setting policies that prevent gaming or manipulation of transfer prices to distort performance evaluations.

Future Policies for Handling Transfer Disputes

To mitigate future disputes, the company should establish clear and consistent transfer pricing policies grounded in strategic and financial principles. Recommendations include:

• Implementing a transfer price range based on a standard cost-plus approach, with a defined minimum (variable cost) and maximum (full cost plus markup).
• Encouraging divisions to negotiate within this range, supplemented by documented rationale to promote transparency.
• Involving the corporate controller in approving transfer prices outside the specified range.
• Regularly reviewing and adjusting transfer pricing policies to reflect changes in costs, market conditions, and company strategy.

Advantages of such policies include enhanced consistency, reduced conflict, and alignment of divisional incentives. Disadvantages may include perceived rigidity and increased bureaucracy, which could slow decision-making.

Conclusion

Determining an appropriate transfer price in the West Island Products case involves carefully balancing cost considerations, divisional incentives, and strategic objectives. A hybrid approach, combining cost-based valuation with market considerations and negotiation, appears most suitable. Establishing formal policies around transfer prices will help prevent disputes, foster cooperation, and support long-term organizational goals. Ultimately, transparency, fairness, and alignment with overall corporate strategy are key to effective transfer pricing management in diversified organizations like WIP.

References

• Drury, C. (2018). Management and Cost Accounting. Cengage Learning.
• Horngren, C. T., Datar, S. M., & Rajan, M. V. (2015). Cost Accounting: A Managerial Emphasis. Pearson.
• Garrison, R. H., Noreen, E. W., & Brewer, P. C. (2018). Managerial Accounting. McGraw-Hill Education.
• Kaplan, R. S., & Atkinson, A. A. (2015). Advanced Management Accounting. Pearson.
• Block, H., & Hirt, G. (2016). Foundations of Financial Management. McGraw-Hill Education.
• Subramaniam, N. (2006). Management Control and Decision Making. Emerald Group Publishing.
• Anthony, R. N., & Govindarajan, V. (2014). Management Control Systems. McGraw-Hill Education.
• Schroeder, R. G., Clark, M. H., & Cathey, J. M. (2019). Financial Accounting Theory and Analysis. Wiley.
• Owen, J., & Trussel, C. (2014). Financial Management for Decision Makers. Cengage Learning.
• Association of Chartered Certified Accountants (ACCA). (2014). Transfer Pricing Guidelines. ACCA Publications.