North Country Auto-Transfer Pricing problem, Page 181, Book: MCS by Vijay Govindarajan & Robert N Anthony Solution:Facts of the case:
(a)North Country Auto has departments/profit centre : (i) New & (ii) Used Car Sales, (iii) Parts, (iv) Service & (v) Body. (b)New & Used cars dept.: Headed by managers. They dealt in cars of Ford, Saab & Volkswagen. (c)Parts dept.: Manager was responsible for tracking parts inventory for the three lines & minimizing both carrying cost & “obsolescence.” (d)Service dept.: The service dept. Occupied over half the building space & was most labour intensive. (e)Body Shop: They consisted of a manager, three technicians & a clerk. Questions to be answered:
(1)Using the data in the transaction, compute the profitability of this one transaction to the new, used, parts, and service dept. Assume a sales commission of $250 for the trade-in on a selling price of $5000. (Note: use the following allocations, new: $835; Used: $665; parts: $32; service: $114, for overhead expenses while computing the profitability of this one transaction. These overhead allocations are also shown as Note 13 in Exhibit
3.) Ans O.H expenses has been converted into for the complete units. Thus for this one transaction the Net Profit will be $10,78,000/- Assumption: Variable Cost for used cars is taken as 87.86% of Sales (as derived from the Financial statement-Exhibit 3). (2)How should the transfer-pricing system operate for each dept (market price, full retail, full cost, variable cost)? AnsThe transfer-pricing should be at Full-cost for all the departments, but at the same time they should act as profit centre & compete with the market for quality & price of service. (3)If it were found one week later that the trade-in could be wholesaled for only $3000, which manager should take the loss? AnsThe loss should be booked on the used-car sales only.
But the management should be conscious that this will be discouraging for the team, hence the incentives has to be designed in such a way, so as to strike a balance between the price of used car & no. of used cars, sold. (4)North country incurred a year-to-date loss of about $59000, before allocation of fixed costs on the wholesaling of used cars (see Note 2 in Exhibit 3). Wholesaling of used cars is theoretically supposed to be a break-even operation. Where do you think the problem lies? AnsThe problem lies with the used- car market. The external conditions were not favourable & hence the dept. couldn’t break even.
(5)Should profit centres be evaluated on gross profit or “full cost” profit? AnsProfit centres has to be evaluated on Full-cost basis only, since financial viability of any profit centre is very important. They compete with the market and any subsidised evaluation, will lead to future accumulation of cost, leading to long-term losses. (6)What advice do you have for the owners?
AnsMy advise to owners to make all the transfer-pricing on the basis of total-cost and at the same time service departments like parts, service & body shop, should give their services to external customers at the market price.