PROBLEM

4.
Listed below are relevant Company Z data for component Smurf that is produced by both Division X and
outsiders and that is an integral part of product Widget that is produced by Division Y:

Y's annual purchase of Smurf ....................................................................................................... 50,000

X's variable cost per unit of Smurf ................................................................................................ $10
X's fixed cost per unit of Smurf ..................................................................................................... $2

Required: Assume that both divisions are profit centers and have the right to buy and sell outside if their
sister divisions don't meet the external market price.

(1) If Division X currently has some idle capacity, will Company Z, as a whole, be better off if Division Y
buys Smurfs outside for $14 each rather than internally for the $15 per-unit selling price that allows
Division X its normal markup?
(2) If Division X could sell all 50,000 units to outside buyers at $15 per unit, will Company Z be better
off if Division Y buys Smurfs outside for $14 each rather than internally for the $15 per-unit selling
price?
(3) If Division X has some idle capacity and the outside market price drops to $11 per unit, which is
below the full cost of $12 per unit in Division X, will Company Z be better off if Division Y buys
Smurfs externally?

SOLUTION

(1) No, the company will be worse off by $200,000 (the difference between the $14 per-unit outside
price and the $10 per-unit variable cost, multiplied by 50,000 units).
(2) Yes, the company will be better off by the difference between the $250,000 contribution margin on
the external sales [$50,000 x ($15 - $10)] and the $200,000 difference in part (1) above, or
$50,000.
(3) No, the company will be worse off by $50,000, which is the difference between the outside price of
$11 per unit and the $10 per-unit variable cost, multiplied by 50,000 units.

PROBLEM

5.
Transfer Pricing. The Chemical Division of Bill Company produces lawn-care chemicals. One-third of
Chemical's output is sold to the Lawn Services Division of Bill; the remainder is sold to outside customers.
The Chemical Division's estimated sales and standard cost data for the year follow:
 Lawn Services Outsiders
Sales .................................................................................................. $ 15,000 $40,000
Variable cost ...................................................................................... (10,000 ) (20,000 )
Fixed cost .......................................................................................... (3,000) (6,000 )
Gross profit ........................................................................................ $ 2,000
............................................................................................. $14,000

Gallons sold ....................................................................................... 5,000 10,000

The Lawn Services Division has an opportunity to purchase 5,000 gallons of identical quality from an outside
supplier at a cost of $1.75 per gallon on a continuing basis. Assume that the Chemical Division cannot sell
any additional products to outside customers, that the fixed costs cannot be reduced, and that no alternative
use of facilities is available.

Required: Should Bill allow its Lawn Services Division to purchase the chemicals from the outside supplier?
Support your answer by computing the increase or decrease in Bill Company operating costs.
(AICPA adapted)

SOLUTION

Yes, because buying the chemicals would save Bill Company $1,250 determined as follows:
Variable cost to manufacture by Chemical Division .............................................................. $ 10,000
Outside supplier cost ($1.75 x 5,000) ................................................................................ 8,750
Savings to Bill if the Lawn Services Division purchases from the
outside supplier ............................................................................................................. $ 1,250

Basic Transfer Pricing: General Rule

71. Bronx Corporation's Gauge Division manufactures and sells product

no. 24, which is used in refrigeration systems. Per-unit
variable manufacturing and selling costs amount to $20 and $5,
respectively. The Division can sell this item to external
domestic customers for $36 or, alternatively, transfer the
product to the company's Refrigeration Division. Refrigeration
is currently purchasing a similar unit from Taiwan for $33.
Assume use of the general transfer-pricing rule.

Required:
A. What is the most that the Refrigeration Division would be
willing to pay the Gauge Division for one unit?
B. If Gauge had excess capacity, what transfer price would the
Division's management set?
C. If Gauge had no excess capacity, what transfer price would the
Division's management set?
D. Repeat part "C," assuming that Gauge was able to reduce the
variable cost of internal transfers by $4 per unit.

LO: 6 Type: A

Answer:
A. Refrigeration would be willing to pay a maximum of $33, its
current outside purchase price.

B. The general rule holds that the transfer price be set at the
sum of outlay cost and opportunity cost. Thus, ($20 + $5) +
 $0 = $25.

C. In this case, the transfer price would amount to $36: ($20 +

$5) + ($36 - $20 - $5).

D. The transfer price would be $32: ($20 + $5 - $4) + ($36 - $20

- $5).
Basic Transfer Pricing

72. Gamma Division of Vaughn Corporation produces electric motors,

20% of which are sold to Vaughan's Omega Division and 80% to
outside customers. Vaughn treats its divisions as profit centers
and allows division managers to choose whether to sell to or buy
from internal divisions. Corporate policy requires that all
interdivisional sales and purchases be transferred at variable
cost. Gamma Division's estimated sales and standard cost data
for the year ended December 31, based on a capacity of 60,000
units, are as follows:

Omega Outsiders
Sales $ $5,760,
660,000 000
Less: Variable costs
660,000 2,640,0
00
Contribution margin $ --- $3,120,
- 000
Less: Fixed costs
175,000 900,000
Operating income $ $2,220,
(loss) (175,00 000
0)

Unit sales
12,000 48,000

Gamma has an opportunity to sell the 12,000 units shown above to

an outside customer at $80 per unit. Omega can purchase the units
it needs from an outside supplier for $92 each.

Required:
A. Assuming that Gamma desires to maximize operating income,
should it take on the new customer and discontinue sales to
Omega? Why? (Note: Answer this question from Gamma's
perspective.)
B. Assume that Vaughn allows division managers to negotiate
transfer prices. The managers agreed on a tentative price of
$80 per unit, to be reduced by an equal sharing of the
additional Gamma income that results from the sale to Omega of
12,000 motors at $80 per unit. On the basis of this
information, compute the company's new transfer price.

LO: 6, 7 Type: A

Answer:
A. Yes. Gamma is currently selling motors to Omega at a transfer
price of $55 per unit ($660,000 ÷ 12,000 units). A price of
$80 to the new customer will increase Gamma Division's
operating income by $300,000 [($80 - $55) x 12,000 units].

B. The additional operating income to Gamma is $300,000 [($80 -

$55) x 12,000 units]. Splitting this amount equally results
in a new transfer price of $67.50, calculated as follows:

Transfer price before reduction $80.00

Less: Omega's per-unit share of
additional income [($300,000 x 12.50
50%) ÷ 12,000 units]
New transfer price $67.50
Transfer Pricing: Selling Internally or Externally

73. Sonoma Corporation is a multi-divisional company whose managers

have been delegated full profit responsibility and complete
autonomy to accept or reject transfers from other divisions.
Division X produces 2,000 units of a subassembly that has a ready
market. One of these subassemblies is currently used by Division
Y for each final product manufactured, the latter of which is
sold to outsiders for $1,600. Y's sales during the current
period amounted to 2,000 completed units. Division X charges
Division Y the $1,100 market price for the subassembly; variable
costs are $850 and $600 for Divisions X and Y, respectively.

The manager of Division Y feels that X should transfer the

subassembly at a lower price because Y is currently unable to
make a profit.

Required:
A. Calculate the contribution margins (total dollars and per
unit) of Divisions X and Y, as well as the company as a whole,
if transfers are made at market price.
B. Assume that conditions have changed and X can sell only 1,000
units in the market at $900 per unit. From the company's
perspective, should X transfer all 2,000 units to Y or sell
1,000 in the market and transfer the remainder? Note: Y's
sales would decrease to 1,000 units if the latter alternative
is pursued.

LO: 6, 7 Type: A

Answer:
A Division X Division Y Company
.
Sales at $ $ 3,200,000
$1,600 3,200,000
Transfers $ 2,200,000 (2,200,000
at $1,100 )
Less:
Variable
costs
at $850 (1,700,000)
at $600 (2,900,000)
(1,200,000
)
Contributio $ 500,000 $ $ 300,000
n margin (200,000)

Unit $ 250 $ $
contributio (100) 150
n margin
B Alternative no. 1: Transfer 2,000 units to Division Y:
.
Company sales (2,000 x $1,600) $3,200,00
0
Less: Variable costs [2,000 x $850) + (2,000 x
$600)] 2,900,000
Contribution margin $
300,000

Alternative no. 2: Sell 1,000 units in the open market and

transfer 1,000 units to Y:

Company sales [(1,000 x $900) + (1,000 x $2,500,00

$1,600)] 0
Less: Variable costs [(2,000 x $850) + (1,000
x $600)] 2,300,000
Contribution margin $
200,000

Division X should transfer all 2,000 units to Division Y to

produce an additional $100,000 ($300,000 - $200,000) of
contribution margin.
Transfer Pricing; Negotiation

74. Kendall Corporation has two divisions: Phoenix and Tucson.

Phoenix currently sells a condenser to manufacturers of cooling
systems for $520 per unit. Variable costs amount to $380, and
demand for this product currently exceeds the division's ability
to supply the marketplace.

Kendall is considering another use for the condenser, namely,

integration into an enhanced refrigeration system that would be
made by Tucson. Related information about the refrigeration
system follows.

Selling price of refrigeration system: $1,285

Additional variable manufacturing costs required: $820
Transfer price of condenser: $490

Top management is anxious to introduce the refrigeration system;

however, unless the transfer is made, an introduction will not be
possible because of the difficulty of obtaining condensers in the
quality and quantity desired. The company uses responsibility
accounting and ROI in measuring divisional performance, and
awards bonuses to divisional management.

Required:
A. How would Phoenix's divisional manager likely react to the
decision to transfer condensers to Tucson? Show computations
to support your answer.
B. How would Tucson's divisional management likely react to the
$490 transfer price? Show computations to support your
answer.
C. Assume that a lower transfer price is desired. What parties
should be involved in setting the new price?
D. From a contribution margin perspective, does Kendall benefit
more if it sells the condensers externally or transfers the
condensers to Tucson? By how much?

LO: 6, 7 Type: A, N
Answer:
A The Phoenix divisional manager will likely be opposed to the
. transfer. Currently, the division is selling all the units
it produces at $520 each. With transfers taking place at
$490, Phoenix will suffer a $30 drop in sales revenue and
profit on each unit that is sent to Tucson.

B Although Tucson is receiving a $30 "price break" on each unit

. purchased from Phoenix, the $490 transfer price would
probably be deemed too high. The reason: Tucson will lose
$25 on each refrigeration system produced and sold.

Sales revenue $1,285

Less: Variable manufacturing costs $820
Transfer price paid to Phoenix 490 1,310
Income (loss) $ (25)

C Kendall uses a responsibility accounting system, awarding

. bonuses based on divisional performance. The two divisional
managers (or their representatives) should negotiate a
mutually agreeable price.

D Kendall would benefit more if it sells the condenser

. externally. Observe that the transfer price is ignored in
this evaluation—one that looks at the firm as a whole.

Produce Produce Condenser;

Condenser; Sell Transfer; Sell
Externally Refrigeration System
Sales revenue $520 $1,285
Less: Variable cost
$380; $380 + $820 380 1,200
Contribution margin $140 $ 85