Transfer Pricing and Capacity at Altura Group
Altura Group has two divisions. Division A makes a proprietary controller. Its variable cost is $60 per unit and capacity is 100,000 units a year. External demand is 80,000 units at $110. Division B assembles a final unit that sells for $300 and incurs $120 of variable conversion cost. B needs 40,000 controllers a year. The current transfer price is $100. B can buy an equivalent controller externally for $95, but the external supplier has a two-year lead time for qualification and less reliable delivery. Division A is in a 25% tax jurisdiction; Division B is in a 10% jurisdiction. Group policy requires arm's-length transfer prices. A's manager refuses to sell below $110 because that is the external price. B's manager wants to buy all 40,000 externally at $95. The group CFO must decide the sourcing and transfer-pricing policy before the annual budget is locked.
1. Determine the group-optimal sourcing plan and the minimum and maximum transfer prices for any internal transfer. Show the contribution calculations for the three options: all internal, all external, and 20,000 internal plus 20,000 external.
Read the worked answer
A has 100,000 units of capacity and external demand of 80,000, so it has 20,000 spare units. B needs 40,000. All internal: A must divert 20,000 units from external sales, so A sells 60,000 externally. A contribution = 60,000 x ($110 - $60) = $3.0m. B contribution = 40,000 x ($300 - $120 - $60) = $4.8m. Group contribution = $7.8m. All external: A sells 80,000 externally = 80,000 x $50 = $4.0m. B contribution = 40,000 x ($300 - $120 - $95) = $3.4m. Group = $7.4m. 20,000 internal plus 20,000 external: A sells 80,000 externally = $4.0m. B contribution = 20,000 x ($300 - $120 - $60) + 20,000 x ($300 - $120 - $95) = $2.4m + $1.7m = $4.1m. Group = $8.1m. The optimal plan is 20,000 internal and 20,000 external. For the 20,000 spare units, the minimum transfer price is A's variable cost of $60 because there is no opportunity cost; the maximum is B's external purchase price of $95. For the next 20,000 units, A would have to give up $50 of external contribution, so the minimum is $60 + $50 = $110, which exceeds B's maximum of $95; no internal transfer is feasible for that tranche.
2. Explain how tax rates and arm's-length rules affect the transfer price. Can the group set a price to shift profit to B, and what documentation is needed?
Read the worked answer
A pays 25% tax and B pays 10%, so the group has an incentive to leave more profit in B. That means a lower transfer price from A to B, not a higher one. At a transfer price of $60 on 20,000 units, A earns no profit and B earns $120 per unit; group tax is 20,000 x $120 x 10% = $240k. At $95, A earns $35 and B earns $85 per unit; group tax is 20,000 x $35 x 25% plus 20,000 x $85 x 10% = $175k + $170k = $345k. A price of $60 is more tax-efficient, but it may not be arm's length because the comparable external price is $95. Tax authorities could adjust A's income upward. The group should set a defensible price within the $60-$95 range, supported by a comparable uncontrolled price analysis, functional analysis, contracts, invoices and contemporaneous documentation. If it chooses $95, it aligns with the external benchmark and reduces tax-audit risk but forgoes tax savings. A's manager will resist $95 only if it is below the $110 external price, but for spare capacity $95 still gives A a $35 contribution and avoids displacing external sales.
3. What qualitative and risk factors should the CFO consider before choosing all external sourcing?
Read the worked answer
The CFO should weigh supply security against the $0.7m group contribution advantage of the mixed plan. The external supplier needs two years for qualification, so B cannot switch immediately without a transition stock or dual-sourcing plan. Less reliable delivery could stop B's assembly line and damage customer service. The controller is proprietary, so external purchase may raise intellectual-property, reverse-engineering and confidentiality risks. A's manager may disengage if the division loses volume, and the group may lose economies of scale and technical feedback between A and B. Tax authorities may challenge the transfer price and require costly documentation. The CFO should also consider foreign-exchange risk, supplier bargaining power, quality warranties and the strategic value of keeping production know-how inside the group. A staged approach may be best: transfer 20,000 internally at an arm's-length price near $95, buy 20,000 externally only after qualification, and review every year.