"I don’t care what you think is required. This transfer price is okay for our external auditors and it’s fine for me." Monty Barnes’ lower jaw quivered in anger. "We’ve been pricing our resins this way for years and I don’t intend to start pricing them differently now."
"Thank you, sir." Fred Harrow was his usual obsequious self. "I thought that way myself, sir. We’ll continue to approve the transfer pricing policy as it currently exists. As head of the internal control group, I assure you that we just want to assist, and not plague you, sir. Let’s go, group, and leave Mr. Barnes to his work."
Quietly, the five members of the internal audit team walked slowly out of the huge, posh office. As they started down the elevator, Fred turned to Betsy and spoke sharply. "I hope you’re satisfied now. We’ve done all we can do on this issue. If the boss thinks we’re harassing him, he’ll simply cut our budget or staff allocation. I’m doing all I can to keep all of you as it is."
Betsy remained silent until the long ride down was finished, and then turned quickly to her small cubicle. Wow, did it seem really tiny now, after seeing the beautiful offices on the executive floor. She recalled how large it had seemed when she had first arrived in Internal Audit.
Betsy had been in Internal Audit for about 4 months now, on a rotation through an executive development program for the controller’s office. She was a recent graduate with her professional accounting designation, and her job at Futura Energy Resources was her first full-time position. She had been very happy as a financial analyst for Futura Explorations, and now the job rotation had positioned her in Internal Audit at Corporate, which exposed her to a large amount of Futura’s business. As an integrated oil producer, Futura’s producing division operated oil fields in Alberta, Texas and the Middle East. Raw feedstock arrived in Sarnia, Ontario by pipeline from Western Canada, and was refined by Futura’s refining division into various products such as gasoline, diesel fuel and resin pellets for plastics. The resin pellets were used internally only, and transfered to Futura Plastics in Toronto, where they were extruded through large extrusion machines into plastic bags for foods, fertilizers and other products.
The apparent independence of the different divisions had fascinated Betsy. Futura’s many companies were operated in a number of different styles, seemingly determined by the divisional general managers. Labour relations styles varied greatly. The oil refinery in Sarnia’s contract with the Canadian Oil Workers union had been in place for many years. Relations with the union here were good at the present time, but it was not a secret that the senior management of Futura were not union friendly. At the time that the union had organized at the refinery, management had feared that all of Futura’s operations might unionized and had fought back with different approaches in each division. They instituted a profit sharing plan to discourage potential union members at the Plastics division. The profit sharing plan was also the means of providing a pension, and many workers at the Plastics Division were elated to receive large bonuses at year end and a substantial deferred payment on retirement. Since payments into the plan depended on the profits for the year, payments were only made when the division made a profit. The plan distributed at least 25% of the profit of the Plastics Division to the employees, the amount varying according to job classification. The profit sharing plan became the basis of Futura Plastics’ well advertised "covenant with employees." Much of Futura Plastics’ corporate advertising focussed on the good relationship between the company and the employees. Futura’s oil field operators were not unionized but received excellent wages based upon production quotas. Senior managers for Futura Energy Resources tended to be chosen from the oil field operations.
On arrival in Internal Audit, Betsy had been assigned to check the interdivisional eliminations of profits to ensure that all transactions were in order for the annual report. She had been shocked by what she had found. Transfer pricing policy for the organization directed that the price of the oil to the refinery division was cost plus 20%. The result of this transaction was that a barrel of oil delivered to the Sarnia refinery cost the refinery $30.00, whereas the current spot price of oil delivered to Sarnia was $25.00. She had been concerned by this differential and had investigated further. The cost per barrel was a function of two major components. First, the company’s pipeline system charged $3.00 per barrel for the delivery. This rate had been set a number of years ago and had been increased by inflation (as determined for the petroleum industry). Second, the price of a barrel of oil at the wellhead was determined by the costs to the firm of lifting the oil, and delivering it to the pipeline. This was done on the basis of standard costs per barrel, as determined by the company, and adjusted for the various taxes etc. that were imposed. Again, a profit margin of 30% was built into the price as delivered to the pipeline. However, the price per barrel was substantially higher than the spot price of sweet Alberta crude. Despite having made significant productivity improvements over the past 5 years, the standard costing system had not been adjusted, resulting in substantial positive variances. It was company policy to purchase internally wherever possible.
Compiling her documentation had been the easiest part of the exercise. Betsy obtained information from other public sources, including industry trade journals. Market prices were publicly quoted, but these were always based upon the spot price and not on the basis of a long term contract. To get information on long term pricing agreements, she contacted a close friend at Moon Oil Company, a competitor. Swearing each other to secrecy, they exchanged the transfer prices that each company used. From this "evidence," it was clear that the transfer price to Futura Plastics was at least 25% higher than market.
Betsy documented all of her findings in a report for Internal Control and presented the case at a monthly group meeting. Fred was unaware of her plans until the evidence was laid out and was forced to agree that there could be some problems with the transfer price. The argument within the group was heated. Fred argued strongly that the transfer price was an internal matter for the company, since no minority shareholders were involved. Since all the companies were Canadian, he felt that the tax implications were negligible. He did agree, however, that royalty charges might be affected by the transfer price. Other members of the group thought the issue was of such concern that they should pursue the matter with the president of the company. Fred reluctantly agreed to lead the delegation.
It was clear from the meeting with the president that he would not change the policy. Betsy was uncertain of her next steps but she knew that her relationship with Fred and, consequently, the company, was in severe danger if she continued with the issue.
If you were Betsy, what would you do?
Other Management Accounting cases:
- Ethical dilemma at Northlake
- Ethical temperature at Articview
- Colin Watson
- Brenda Williams
- Betsy Smith
- Kendrickville Community Church
- The subcontractor
- A small matter of trimming