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 ....................................................................................................... X's variable cost per unit of Smurf ................................................................................................ X's fixed cost per unit of Smurf ..................................................................................................... 50,000 $10 $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) (2) 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). 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 Sales .................................................................................................. Variable cost ...................................................................................... Fixed cost .......................................................................................... Gross profit ........................................................................................ ............................................................................................. $14,000 Gallons sold ....................................................................................... 5,000 10,000 $ $ 15,000 (10,000 ) (3,000) 2,000 Outsiders $40,000 (20,000 ) (6,000 )

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 .............................................................. Outside supplier cost ($1.75 x 5,000) ................................................................................ Savings to Bill if the Lawn Services Division purchases from the outside supplier ............................................................................................................. $ 1,250 $ 10,000 8,750

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

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 Less: Omega's per-unit share of additional income [($300,000 x 50%) 12,000 units] New transfer price $80.00 12. 50 $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 Division X $ 2,200,000 Division Y Company $ 3,200,000 $ 3,200,000 (2,200,000)

Answer: A. Sales at $1,600 Transfers at $1,100 Less: Variable costs at $850 at $600 Contribution margin

(1,700,000) $ 500,000 (2,900,000) (1,200,000) $ $ 300,000 (200,000)

Unit $ 250 $ $ contribution (100) 150 margin B. Alternative no. 1: Transfer 2,000 units to Division Y: Company sales (2,000 x $1,600) Less: Variable costs [2,000 x $850) + (2,000 x $600)] Contribution margin $3,200,000 2,900,000 $ 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 $1,600)] Less: Variable costs [(2,000 x $850) + (1,000 x $600)] Contribution margin $2,500,000 2,300,000 $ 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 purchased from Phoenix, the $490 transfer probably be deemed too high. The reason: $25 on each refrigeration system produced break" on each unit price would Tucson will lose and sold.

Sales revenue Less: Variable manufacturing costs Transfer price paid to Phoenix Income (loss) C .

$1,285 $820 490 1,310 $ (25)

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. Kendall would benefit more if it sells the condenser externally. Observe that the transfer price is ignored in this evaluationone that looks at the firm as a whole. Produce Condenser; Sell Externally $520 380 $140 Produce Condenser; Transfer; Sell Refrigeration System $1,285 1,200 85

D .

Sales revenue Less: Variable cost $380; $380 + $820 Contribution margin