PROBLEM 13-49 (40 MINUTES)

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Answer:
1. Among the reasons transfer prices based on total actual costs are not appropriate as a
divisional performance measure are the following:

They provide little incentive for the selling division to control manufacturing costs, because
all costs incurred will be passed on to the buying division.

They often lead to suboptimal decisions for the company as a whole, because they can
obscure cost behavior. Costs that are fixed for the company as a whole can be made to
appear variable to the division buying the transferred goods.

2. Using the market price as the transfer price, the contribution margin for both the
Mining Division and the Metals Division is calculated as follows:
Mining Metals
Division Division

Selling price $90 $150

Less: Variable costs:

Direct material 12 6
Direct labor 16 20
Manufacturing overhead 24* 10†
Transfer price  90
Unit contribution margin $38 $ 24
Volume x 400,000 x 400,000

Total contribution margin $15,200,000 $9,600,000

*Variable overhead = $32 x 75% = $24

†Variable overhead = $25 x 40% = $10

Note: the $5 variable selling cost that the Mining Division would incur for sales on the open
market should not be included, because this is an internal transfer.

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3. If PCRC instituted the use of a negotiated transfer price that also permitted the
divisions to buy and sell on the open market, the price range for toldine that would be
acceptable to both divisions would be determined as follows.

The Mining Division would like to sell to the Metals Division for the same price it can obtain
on the outside market, $90 per unit. However, Mining would be willing to sell the toldine for
$85 per unit, because the $5 variable selling cost would be avoided.

The Metals Division would like to continue paying the bargain price of $66 per unit.
However, if Mining does not sell to Metals, Metals would be forced to pay $90 on the open
market. Therefore, Metals would be satisfied to receive a price concession from Mining
equal to the costs that Mining would avoid by selling internally. Therefore, a negotiated
transfer price for toldine between $85 and $90 would be acceptable to both divisions and
benefits the company as a whole.

4. General transfer-pricing rule:

Transfer price = outlay cost + opportunity cost
= ($12 + $16 + $24)* + ($38 - $5) **
= $52 + $33 = $85
*Outlay cost = direct material + direct labor + variable overhead [see requirement (2)]
**Opportunity cost = forgone contribution margin from outside sale on open market
= $38 contribution margin from internal sale calculated in requirement (2), less the additional
$5 variable selling cost incurred for an external sale

Therefore, the general rule yields a minimum acceptable transfer price to the Mining Division
of $85, which is consistent with the conclusion in requirement (3).

5. A negotiated transfer price is probably the most likely to elicit desirable management
behavior, because it will do the following:

Encourage management of the Mining Division to be conscious of cost control.

Benefit the Metals Division by providing toldine at a lower cost than that of its competitors.
Provide the basis for a more realistic measure of divisional performance
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