Apply Transfer Pricing Rules

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15-17. Apply Transfer Pricing Rules

Best Practices, Inc., is a management-consulting firm. Its Corporate Division advises private firms on the adoption and use of cost management systems. Government Division consults with state and local governments. Government Division has a client that is interested in implementing an activity-based costing system in its public works department. The division’s head approached the head of Corporate Division about using one of its associates. Corporate Division charges clients $600 per hour for associate services; the same rate other consulting companies charge. The Government Division head complained that it could hire its own associate at an estimated variable cost of $200 per hour, which is what Corporate pays its associates.

Required

1. What is the minimum transfer price that Corporate Division should obtain for its services, assuming that it is operating at capacity?

If corporate division is already operating at capacity, then they should charge a minimum of current market rate of $600 per hour for their associate services. Because the corporate division is already full, their associates are already bringing in $600/ hour through their services. Hence it wouldn’t make any sense for the corporate firm to go below $600.

1. What is the maximum price that Government Division should pay?

Government division should pay a maximum transfer price of $200 per hour which is the cost of the best alternative of hiring it’s own associate.

1. Would your answers in (a) or (b) change if Corporate Division had idle capacity? If so,  which answer would change, and what would the new amount be?

If corporate division had idle capacity then answer (b) wouldn’t change. But however (a) answer would change. The new amount for (a) would now be $200/hour. Because the division is not operating at full capacity, they have many associates who are sitting idle and the corporate division should be ready to accept a minimum transfer price of what it pays it’s own associates.

Caja Espana Case Analysis:

1. The case describes transfer pricing system at Caja Espana

1. Use the adjustment rates in Exhibit 6 to calculate the profit of the Gradefes and Madrid-Barrio de Salamanca branches.

While calculating the profits for the Madrid bank, the expenses incurred on the rent are not taken into account. Gradefes branch property is owned by Caja Espana and has been depreciated completely and hence we do not have rental expenses for this branch. To make sure we compare banks just on their performance, we have not included the rental expenses incurred on Madrid bank. Also branches in the same location could be opened at different points in time and the rents they pay might be different although they are in same location. Hence, it is very unfair to include rents in calculation of your commercial profit.