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TransferPricingExercise

CrangoProductsisacranberrycooperativethatoperatestwodivisions,aharvesting
divisionandaprocessingdivision.Currently,allofharvestingsoutputisconverted
intocranberryjuicebytheprocessingdivision,andthejuiceissoldtolargebeverage
companiesthatproducecranberryjuiceblends.Theprocessingdivisionhasayieldof
500gallonsofjuiceper1,000poundsofcranberries.Costandmarketpricedatafor
thetwodivisionsareasfollows:

Required:
1. Compute Crangos operating income from harvesting 400,000
pounds of cranberries during June 2012 and processing them
into juice.
2. Crango rewards its division managers with a bonus equal to
5% of operating income. Compute the bonus earned by each
division manager in June 2012 for each of the following
transfer pricing methods: a. 200% of full costb. Market price
3. Which transfer-pricing method will each division manager
prefer? How might Crango resolve any conflicts that may arise
on the issue of transfer pricing?

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22-30 (3035 min.) Efect of alternativetransfer-pricingmethodson division operating


Answer:
income.

1.
Pounds of cranberries harvested
Gallons of juice processed (500 gals per 1,000 lbs.)
Revenues (200,000 gals. $2.10 per gal.)
Costs
Harvesting Division
Variable costs (400,000 lbs. $0.10 per lb.)
Fixed costs (400,000 lbs. $0.25 per lb.)
Total Harvesting Division costs
Processing Division
Variable costs (200,000 gals. $0.20 per gal.)
Fixed costs (200,000 gals. $0.40 per gal.)
Total Processing Division costs
Total costs
Operating income

400,000
200,000
$420,000
$ 40,000
100,000
140,000
$ 40,000
80,000
120,000
260,000
$160,000

2.
Transfer price per pound (($0.10 + $0.25)

2; $0.60)

1. Harvesting Division
Revenues (400,000 lbs. $0.70; $0.60)
Costs
Division variable costs (400,000 lbs. $0.10 per lb.)
Division fixed costs (400,000 lbs. $0.25 per lb.)
Total division costs
Division operating income
Harvesting Division manager's bonus (5% of operating income)
2. Processing Division
Revenues (200,000 gals. $2.10 per gal.)
Costs
Transferred-in costs
Division variable costs (200,000 gals. $0.20 per gal.)
Division fixed costs (200,000 gals. $0.40 per gal.)
Total division costs
Division operating income
Processing Division managers bonus (5% of operating income)

22-27

200% of
Full Costs
$0.70

Market
Price
$0.60

$280,000

$240,000

40,000
100,000
140,000
$140,000
$7,000

40,000
100,000
140,000
$100,000
$5,000

$420,000

$420,000

280,000
40,000
80,000
400,000
$ 20,000
$ 1,000

240,000
40,000
80,000
360,000
$ 60,000
$ 3,000

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3.
Bonus paid to division managers at 5% of division operating income is computed above
and summarized below:
Internal Transfers
Internal Transfers
at 200% of Full Costs at Market Prices
Harvesting Division managers bonus
(5% $140,000; 5% $100,000)

$7,000

$5,000

Processing Division managers bonus


(5% $20,000; 5% $60,000)

$1,000

$3,000

The Harvesting Division manager will prefer to transfer at 200% of full costs because this
method gives a higher bonus. The Processing Division manager will prefer transfer at market
price for its higher resulting bonus.
Crango may resolve or reduce transfer pricing conflicts by:
Basing division managers bonuses on overall Crango profits in addition to division
operating income. This will motivate each manager to consider what is best for
Crango overall and not be concerned with the transfer price alone.
Letting the two divisions negotiate the transfer price between themselves. However,
this may result in constant re-negotiation between the two managers each accounting
period.
Using dual transfer prices However, a cost-based transfer price will not motivate cost
control by the Harvesting Division manager. It will also insulate that division from
the discipline of market prices.

22-28

Exercise:
1. BritishColumbiaLumberhasarawlumberdivisionandafinishedlumberdivision.
Thevariablecostsareasfollows:

Rawlumberdivision:$100per100boardfeetofrawlumber

Finishedlumberdivision:$125per100boardfeetoffinishedlumber

Assumethatthereisnoboardfeetlossinprocessingrawlumberintofinishedlumber.
Rawlumbercanbesoldat$200per100boardfeet.Finishedlumbercanbesoldat
$275per100boardfeet.
a. Should British Columbia Lumber process raw lumber into its finished
form?Showyourcalculations.
b. Assumethatinternaltransfersaremadeat110%ofvariablecost.Willeach
divisionmaximizeitsdivisionoperatingincomecontributionbyadopting
theactionthatisinthebestinterestofBritishColumbiaLumberas a
whole?Explain.
c. Assume that internal transfers are made at market prices. Will each
divisionmaximizeitsdivisionoperatingincomecontributionbyadopting
theactionthatisinthebestinterestofBritishColumbiaLumberas a
whole?Explain.

2. AjaxCorporationhastwodivisions.Theminingdivisionmakestoldine,whichis
then transferred tothe metals division.The toldineis further processedbythe
metalsdivisionandissoldtocustomersatapriceof$150perunit.Themining
divisioniscurrentlyrequiredbyAjaxtotransferitstotalyearlyoutputof200,000
units of toldine to the metals division at 110% of full manufacturing cost.
Unlimitedquantitiesoftoldinecanbepurchasedandsoldontheoutsidemarketat
$90perunit.
Thefollowingtablegivesthemanufacturingcostperunitintheminingandmetals
divisionsfor2012:

a. Calculatetheoperatingincomesfortheminingandmetalsdivisionsfor
the 200,000 units of toldine transferred under the following transfer
pricingmethods:(a)marketpriceand(b)110%offullmanufacturingcost.
b. SupposeAjaxrewardseachdivisionmanagerwithabonus,calculatedas
1%ofdivisionoperatingincome(ifpositive).Whatistheamountofbonus
that will be paid to each division manager under the transferpricing
methods in requirement 1? Which transferpricing method will each
divisionmanagerprefertouse?
c. WhatargumentswouldBrianJones,manageroftheminingdivision,make
tosupportthetransferpricingmethodthatheprefers?