AJAX Corp.

Transfer Pricing Problem

1. Calculate income for each division for the 400,000 units of Toldine transferred,
assuming senior management requires a TP at market price.

Mining Metals
Sales rev. 400,000 x $90 $36 million 400,000 x $150 $60 million
Cost. 400,000 x $60 24 m Cost of TP 36 m
Costs added 20.4 m
Division income $12 million $ 3.6 million

2. Calculate TP assuming senior management requires it be set at 110% of full cost.

Mining Metals
Sales rev. 400,000 x $66 $26.4 million 400,000 x $150 $60 million
Cost. 400,000 x $60 24 m Cost of TP 26.4 m
Costs added 20.4 m
Division income $2.4 million $13.2 million

3. If bonuses are 1% of divisional income, which method will the manager of each
division prefer?

Mining Division manager will prefer the market price based approach because the bonus will be
$120,000. (1% x $12 million)
Metals Division manager will prefer the cost based approach because the bonus will be $132,000
(1% x $13.2 million)

Note that under either approach, the company as a whole benefits by an increase in profits
of $15.6 million; however the different approaches impact the divisions differently.

4. What arguments would the Mining Division’s manager make to support the
market-price approach that he/she would prefer?
a. Toldine appears to be a perfectly competitive market product because the
company can sell all it can produce externally.
b. Mining is entitled to the profit it could earn by selling to external customers.
c. A cost-based approach would provide less incentive to control costs because total
cost –whatever it is – would be recovered and a 10% profit margin is guaranteed.

5. If senior management did not require a transfer, what would likely happen?

It depends on Mining Division’s strategy and Metal Division’s cost. If Mining sees this as a way
to have a long-term relationship with a steady buyer, then it might be happy to sell all its product
to Metals. If Mining wants to encourage the development of its external market, it will sell
externally and Metals would have to buy from an external supplier. Since this is a perfectly
competitive market, Metals should be able to buy at $90 externally; thus, the company’s total
profits will increase by $15.6 million regardless of where the Toldine is ultimately sold.
 6. What would happen if senior management promoted the negotiated approach.
What would be the range within which the TP would fall?

As the facts currently stand, there is no negotiable range. Mining’s minimum selling price is the
sum of its incremental cost and any opportunity cost. Incremental cost to manufacture is $52
(total variable cost). It opportunity cost is the contribution margin per unit X units forfeited X
number of units transferred. This would be $38 ($90 - $52VC) X 4000,000 spread over 400,000
units. Thus, $52 + $38 = $90 – the market price. The range, therefore, would be from a
minimum SP of $90 to a maximum TP of $90 – the price that Metals has to pay to an external
supplier.

7. If the facts change, and Mining can sell only 320,000 units externally but still has a
capacity to make 400,000 units, and Metals wants only 80,000 units, then a negotiated range
exists. Mining has sufficient capacity to meet Metals’ needs without incurring any opportunity
cost; therefore, the range would be from a minimum SP acceptable of $52 to a $90 maximum
above which Metals will not pay.

8. If the facts are similar to Item 7, but Metal’s needs 100,000 units, not 80,000. the
minimum selling price is the sum of the $52 incremental cost plus an opportunity cost of $7.60
per unit. ($38 contribution margin x 20,0000 external sales given up spread over the 100,000
units needed by Metals.) This raises the minimum TP to $50.60. The maximum of $90 stays the
same.