Coffee Makers Incorporated: Cmithree Divisions Of CMI

Coffee Makers Incorporated Cmithree Divisions Of A Cmi Are Involved

Coffee Makers Incorporated (CMI) has three divisions involved in a dispute over the purchase of parts and transfer pricing policies. Division A and Division B currently purchase parts from Division C internally, with external suppliers also providing these parts at market prices. Recently, outside suppliers have lowered their prices, and division managers seek more flexibility to buy externally to enhance profitability. The divisions are considering proposals to adjust their purchasing strategies, which has implications for internal transfer prices and overall division profitability. This analysis aims to evaluate the financial impact of current and proposed arrangements, particularly focusing on transfer pricing, operating income, and divisional gains or losses.

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Introduction and Background

Effective transfer pricing is essential in multi-divisional corporations like Coffee Makers Incorporated, where divisions operate semi-autonomously yet share resources and responsibilities. The dispute among Divisions A, B, and C centers on whether to continue the existing transfer prices or to adopt a more flexible purchasing approach that incorporates external suppliers. With the decline in external market prices, divisions A and B are motivated to purchase more externally, increasing their profit margins, while Division C aims to sell all its output internally at current transfer prices. This scenario necessitates a detailed financial analysis to understand the implications of different purchasing strategies and transfer pricing policies on divisional performance and overall corporate profitability.

Current Situation Analysis

Under the current arrangements, Division A purchases 2,700 units of Part 101 from Division C at a transfer price of $1,000 per unit while sourcing an additional 1,300 units externally at market prices. Division B purchases 1,100 units of Part 201 from Division C at $2,000 per unit and 700 units externally at market prices. Division C produces and sells all parts internally to Divisions A and B, maintaining a fixed transfer price structure. The fixed and variable costs for Division C are $1,200 and $700 to $1,200 per unit for the respective parts, with fixed overhead totaling $1,200,000. Analyzing the current scenario shows that internal transfer prices may not reflect current market conditions, potentially leading to suboptimal decision-making.

Proposed Changes and Financial Impact

The proposed plan suggests that Divisions A and B purchase some units externally at the current market prices—$900 per unit for Part 101 and $1,800 per unit for Part 201—while also continuing internal purchases at the existing transfer prices. This hybrid approach aims to leverage external market efficiencies and reduce costs, especially relevant given the recent decline in external prices. Calculations using Excel or similar tools reveal the total cost implications, divisional savings, and the corresponding impact on each division's operating income. For instance, Division A would save approximately $7 per unit on the 1,300 units purchased externally, and Division B would save about $4 per unit on its 700 units, which can be quantified in dollar terms to support managerial decision-making.

Impact on Division C's Operating Income

Division C's income depends on the transfer prices and the volume sold internally. Under the current arrangement, the contribution margin per unit is computed by subtracting variable costs from transfer prices, with fixed overhead allocated across all units. Transitioning to a hybrid purchasing approach might reduce internal transfer volumes but could potentially increase overall profitability if external purchase prices are lower than existing transfer prices. Analyzing the operating income under both arrangements reveals whether Division C will face a decline in contribution margin or gain from higher external sales, thus influencing divisional strategies.

Evaluating the Proposed Agreement

The key question is whether the revised purchasing strategy benefits the overall company. If divisions A and B purchase externally at lower prices, they realize immediate cost savings, enhancing their profitability. However, if Division C's income declines significantly due to lower internal transfer volume or reduced transfer prices, the net effect on the company must be carefully considered. The total savings and losses across all divisions can be evaluated by summing individual impacts, and decision models can guide whether the company should adopt more flexible transfer pricing policies or maintain the status quo. Generally, aligning transfer prices more closely with external market prices can lead to more efficient resource allocation and better decision-making.

Conclusion and Recommendations

Based on the detailed financial analysis, it is advisable that Coffee Makers Incorporated consider adopting a more market-oriented transfer pricing policy that reflects external prices. This approach encourages divisions to pursue the most cost-effective sourcing, promotes transparency, and aligns internal incentives with external market conditions. Specifically, enabling divisions to purchase externally when prices are lower than internal transfer prices can improve divisional profitability without necessarily harming overall corporate income. Nonetheless, the company should implement guidelines to ensure internal transactions remain fair and that Division C remains incentivized to continue producing the parts. Overall, a policy that balances internal transmission and external sourcing—supported by data-driven analysis—will foster more efficient decision-making and enhance profitability across all divisions.

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