Durst Industries Inc. (Durst), a multinational company, has its head office in Western Canada. Shares are listed on Canadian stock exchanges and on several foreign exchanges. For the fiscal year ended June 30, 2009, consolidated net sales amounted to $1.2 billion and net income was $45 million. The company manufactures and markets heavy-construction and farm equipment at its 22 separate manufacturing facilities located in Canada, the United States, South America, Europe, and Asia. In this highly competitive, price-sensitive industry, Durst has maintained a reputation for high-quality, durable products. However, it recently lost several major contracts for farm tractors and combines. 

While there is head office control of Durst’s marketing and manufacturing strategies, the company’s 22 manufacturing plants are treated as separate profit centres. Most of the subassembly and component parts are produced for internal use in the assembly of end products. There is no external market for most of these intermediate items. Those that are sold externally now generate approximately 2 percent of consolidated net sales. Selling prices to outsiders for subassembly and component parts have usually been determined at the plant level. The following policy applies to transfers of goods between various Durst profit centres: 

development and implementation of company marketing and manufacturing strategies, senior management needs to evaluate decentralized operations using a profit-centre concept. This is very important because the company’s main production activity is focused on manufacturing subcomponents and subassemblies used exclusively for internal assembly of end products for consumers. Accordingly, there is a need for an appropriate pricing structure for interplant transfers. For guidance in determining transfer prices, plant managers should first refer to prices already established for outside sales. When there is no outside market, or when outside prices are not readily determinable, transfer prices are to be based on laid-down cost to the producing plant, plus a reasonable profit. This latter approach to arriving at a fair transfer price is consistent with the concept of “value-added pricing.” 

Thomas Smith, president and chief executive officer of Durst, received the following memorandum dated September 1, 2009, from Jim Brown, plant manager in Tulsa, Oklahoma. I have done everything I can to negotiate a fair price for our modified X-30 carburetor used in the assembly of the DXL 1300 tractor at our plant in Eastern Canada. Roger Bertrand, the manager of this plant, has been most unreasonable, given that my modified X-30 is manufactured exclusively for installation in his DXL 1300 tractors. As you know, we still manufacture the unmodified version of the X-30, and its sales to our customers are substantial throughout the West. Unless you can convince Bertrand to be more reasonable, I shall cease production of the modified X-30 and concentrate our efforts on manufacturing the unmodified carburetor. I expect you to let me know within ten days whether you have been able to convince Bertrand on this issue. Advise him that my last offer remains at $575 U.S., F.O.B. Tulsa. 

Smith immediately called in Jean Talbot, CMA, vice president, finance, to discuss Brown’s memo. Smith then asked Talbot to investigate the dispute.  

Talbot obtained the following information, which she related to Smith: 

1. Unmodified X-30s were currently priced at U.S.$365.00, F.O.B. Tulsa.

2. Sales volume of the unmodified X-30 had dropped significantly during the last three years, and during this time its market price had similarly declined. 

3. The modified X-30 represented a significant advance in carburetor technology. 

4. To date, corporate management has not permitted production of the modified version for sale on the open market. 

5. Tulsa’s pricing of the modified X-30 was found to be in accord with company policy. The difference in price between these models is attributed to the additional cost of production plus the recovery of related development costs, overhead, and provision for “normal profit margin.” 

6. Costs incurred in the manufacture of carburetors at Tulsa are considered to be 60 percent variable and 40 percent fixed. Tulsa’s gross margin on the carburetors has declined in recent years and is currently 35 percent. 

7. When approached by Talbot, Bertrand would not reconsider his position. He contended that the Tulsa price was unacceptable because of the duty and excise taxes he would necessarily incur to import the modified X-30 from the United States. He mentioned the availability of a less expensive but clearly inferior carburetor manufactured by a local competitor. In discussions with Smith, Talbot emphasized that, while this dispute must be resolved, other problems existed. The present transfer pricing policy appears to have broader, long-range implications and the system might not be properly serving Durst’s overall needs. At the conclusion of their discussion, Smith asked Talbot to prepare a report on the matter.