ME5 Problem: Transfer Pricing – Canadian Motors International

ME5 Problem: Transfer Pricing – Canadian Motors International

Canadian Motors International (CMI) is an international company that is organized into threedivisions, each of which is treated as an investment centre. Divisional performance evaluationand managerial bonuses are based on achieving a 12% divisional return on investment (ROI).Divisional ROI is calculated as pretax divisional income divided by divisional investment. SeeExhibit 1 for a diagram showing the structure of CMI.Paul Sing, President of CMI, is very concerned about both divisional and overall corporate performance. The following discussion took place recently between Paul Sing and Erin Hunter,the new controller.Paul Sing, President: "I wonder if the growth we enjoyed in the early eighties was really worth it. Now that we're an international organization, I'm not sure what's going on in each of thedivisions."Erin Hunter, Controller: "But you've laid out some ground rules for the divisional managers towork within. I heard you say this morning that they are supposed to act as independent businessunits and maximize divisional return on investments."Paul Sing, President: "I 've also instructed the divisional managers to buy from and sell to eachother whenever possible and that the price for these internal transactions has to be set at 1.25times full production cost. Every time I turn around, one of them is complaining about what theother divisions are doing."The Engine Division (ED) manufactures standard carburetor engines and fuel injected engines.The manufacturing process involves product design, machining of parts, assembly, and qualityassurance. ED has developed a strong reputation based on product quality and the guarantee of complete customer satisfaction. Lately, CMI management has expressed some concernsregarding the overall profitability of ED given CMI's overall desired rate of return of 12% beforetaxes (the corporate tax rate in Canada is 40%). All of the carburetor engines produced by ED aresold to the Snowmobile Division (SD) of CMI.Information concerning the manufacture of the engines is provided in Exhibit 2. The manager of ED has been complaining that his division's ROI is decreasing as carburetor engine sales to SDincrease. He has argued with Paul Sing that he should be allowed to increase the price of carburetor engines to $500 which is the market price for a similar engine. Alternatively, the EDmanager has threatened to stop producing carburetor engines. Sales prospects for the fuelinjected engine are virtually limitless at the current price of $600 per engine. The only restrictionfacing ED is an upper limit of 200,000 machine hours per year.The Snowmobile Division (SD) manufactures snowmobiles valued for their durability and performance. Information on the profitability of SD is shown in Exhibit 3. SD buys all of itscarburetor engines from ED.

Paul Sing has been pleased with the past performance of SD as sales and profits have continuedto increase. He decided to ask the SD manager how a price increase in carburetor engines wouldaffect sales. The reply was that snowmobile sales are price sensitive and the proposed increase inthe price of engines from ED would require SD to increase the domestic price of the snowmobileto $3,400. This would cause the domestic sales volume to fall to 3,500 units per year. The SDmanager also complained that ED's service has steadily decreased over the past year, causingdelays in the production of snowmobiles, and if delivery times do not improve, some sales could be lost.The International Division (ID) of CMI is located in Sweden where the corporate tax rate is 30%.ID's only business activity is to sell snowmobiles imported from SD. ID pays a 20% import duty based on the transfer price. Customs officials in Sweden carefully monitor the invoices of imported manufactured goods to ensure that the goods are priced at "fair values". Thegovernment of Sweden considers any price between full production cost and 150% of full production cost to be within its definition of fair value. Information on ID is provided in Exhibit4.While ID is only two years old, it has gained a significant market share in Sweden by following a penetration pricing strategy. All indications are that sales will continue to grow. In response to arecent inquiry by Paul Sing, ID's manager indicated that the proposed increase in the cost of asnowmobile from SD would lead him to increase the ID sales price by $300 per unit causingvolumes to decline to 1,700 per year.At the end of their meeting, Paul Sing requested Erin Hunter to analyze the company's currentsituation, including the ED manager's two proposals, and recommend improvements.Specifically, he would like you to determine the impact of each proposal on the pretax incomeand return on investment for each division and the company as a whole along with the behavioralimplications of these proposals. Paul Sing would also like a discussion of the relevantconsiderations in setting CMI's domestic and international transfer pricing policies. Other issues,such as organization structure, performance evaluation, the bonus system and improvement of the company's future profitability, are other concerns Paul Sing would like you to address.

 Required -

As Erin Hunter, the new controller, prepare a report to Paul Sing, President of Canadian Motors International