Transfer Pricing Exercise Plus Answer

Transfer Pricing Exercise

Crango Products is a cranberry cooperative that operates two divisions, a harvesting division and a processing division. Currently, all of harvesting’s output is converted into cranberry juice by the processing division, and the juice is sold to large beverage companies that produce cranberry juice blends. The processing division has a yield of 500 gallons of juice per 1,000 pounds of cranberries. Cost and market price data for the two divisions are as follows:

A

Harvesting Division

1 2 3 4

B

Variable cost per pound of cranberries Fixed cost per pound of cranberries Selling price per pound of cranberries in outside market

C

D

E

Processing Division

$0.10 $0.25 $0.60

Variable processing cost per gallon of juice produced Fixed cost per gallon of juice produced Selling price per gallon of juice

$0.20 $0.40 $2.10

"#$%&'#() *+ ,-./%0# ,'123-45 -/#'10&23 &26-.# 7'-. 81'9#50&23 :;;%2# ?;*? 12( /'-6#55&23 08#. &20- @%&6#+ @%& 6#+ ?+ ,'123- '#A1'(5 &05 (&9&5&-2 .1213#'5 A&08 1 =-2%5 #$%1B 0- CD -7 -/#'10&23 &26-.#+ ,-./%0# 08# =-2%5 #1'2#( =E #168 (&9&5&-2 .1213#' &2 >%2# ?;*? 7-' #168 -7 08# 7-BB-A&23 0'1257#' /'&6&23 .#08-(5) 1+ ?;;D -7 7%BB 6-50 =+ F1'G#0 /'&6# H+ I8&68 0'1257#'J/'&6&23 .#08-( A&BB #168 (&9&5&-2 .1213#' /'#7#'K L-A .&380 ,'123- '#5-B9# 12E 6-27B&605 0810 .1E 1'&5# -2 08# &55%# -7 0'1257#' /'&6&23K

 !"#$%&'

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)

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

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 manager’s bonus (5% of operating income)

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 manager’s bonus (5% ! $140,000; 5% ! $100,000)

$7,000

$5,000

Processing Division manager’s 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.

)*%&+,#%'

1. British Columbia Lumber has a raw lumber division and a finished lumber division. The variable costs are as follows: •

Raw lumber division: $100 per 100 board-feet of raw lumber

•

Finished lumber division: $125 per 100 board-feet of finished lumber

Assume that there is no board-feet loss in processing raw lumber into finished lumber. Raw lumber can be sold at $200 per 100 board-feet. Finished lumber can be sold at $275 per 100 board-feet. a. Should British Columbia Lumber process raw lumber into its finished form? Show your calculations. b. Assume that internal transfers are made at 110% of variable cost.Will each division maximize its division operating-income contribution by adopting the action that is in the best interest of British Columbia Lumber as a whole? Explain. c. Assume that internal transfers are made at market prices. Will each division maximize its division operating-income contribution by adopting the action that is in the best interest of British Columbia Lumber as a whole? Explain.

1.

 Alternative 1:

Sell as raw lumber for $200 per 100 board feet:

Revenue Variable costs Contribution margin  Alternative 2:

$200 100 $100 per 100 board feet

Sell as finished lumber for $275 per 100 board feet:

Revenue Variable costs: Raw lumber Finished lumber Contribution margin

$275 $100 125

225 $ 50 per 100 board feet

British Columbia Lumber will maximize its total contribution margin by selling lumber in its raw form. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $275  –  $200 Incremental costs Incremental loss 2.

$ 75 125 $ (50) per 100 board feet

Transfer price at 110% of variable costs: = $100 + ($100 0.10) = $110 per 100 board feet Sell as Raw Lumber

Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income

Sell as Finished Lumber

$200 100 $100

$110 100 $ 10

$

$275 110 125 $ 40

0

 —  $

0

The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by selling finished lumber, which is contrary to the action preferred by the company as a whole.

3.

Transfer price at market price = $200 per 100 board feet.

Raw Lumber Division Division revenues Division variable costs Division operating income Finished Lumber Division Division revenues Transferred-in costs Division variable costs Division operating income

Sell as

Sell as

Raw Lumber

Finished Lumber

$200 100 $100

$200 100 $100

$

$275 200 125 $ (50)

0

 —   —  $

0

Since the Raw Lumber Division will be indifferent between selling the lumber in raw or finished form, it would be willing to maximize division operating income by selling raw lumber, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by not further processing raw lumber and this is preferred by the company as a whole. Thus, transfer at market price will result in division actions that are also in the best interest of the company as a whole.

2. Ajax Corporation has two divisions. The mining division makes toldine, which is then transferred to the metals division. The toldine is further processed by the metals division and is sold to customers at a price of $150 per unit. The mining division is currently required by Ajax to transfer its total yearly output of 200,000 units of toldine to the metals division at 110% of full manufacturing cost. Unlimited quantities of toldine can be purchased and sold on the outside market at $90 per unit. The following table gives the manufacturing cost per unit in the mining and metals divisions for 2012:

Direct material cost Direct manufacturing labor cost Manufacturing overhead cost Total manufacturing cost per unit

Mining Division $12 16 ƒ32 a

$60

Metals Division $ 6 20 ƒ25 b

$51  

a

Manufacturing overhead costs in the mining division are 25% fixed and 75% variable. Manufacturing overhead costs in the metals division are 60% fixed and 40% variable.

b

a. Calculate the operating incomes for the mining and metals divisions for the 200,000 units of toldine transferred under the following transferpricing methods: (a) market price and (b) 110% of full manufacturing cost. b. Suppose Ajax rewards each division manager with a bonus, calculated as 1% of division operating income (if positive). What is the amount of bonus that will be paid to each division manager under the transfer-pricing

methods in requirement 1? Which transfer-pricing method will each division manager prefer to use? c. What arguments would Brian Jones, manager of the mining division, make to support the transfer-pricing method that he prefers?

Method A Internal Transfers at Market Prices

1.  Mining Division Revenues: $90, $661 200,000 units Costs: Division variable costs: $522 200,000 units Division fixed costs: $83 200,000 units Total division costs Division operating income  Metals Division Revenues: $150 200,000 units Costs: Transferred-in costs: $90, $66 200,000 units Division variable costs: $364 200,000 units Division fixed costs: $155 200,000 units Total division costs Division operating income

Method B Internal Transfers at 110% of Full Costs

$18,000,000

$13,200,000

10,400,000

10,400,000

1,600,000 12,000,000 $ 6,000,000

1,600,000 12,000,000 $ 1,200,000

$30,000,000

$30,000,000

18,000,000

13,200,000

7,200,000

7,200,000

3,000,000 28,200,000 $ 1,800,000

3,000,000 23,400,000 $ 6,600,000

1

$66 = Full manufacturing cost per unit in the Mining Division, $60

2

110%

Variable cost per unit in Mining Division = Direct materials + Direc t manufacturing labor + 75% of manufacturing overhead = $12 + $16 + (75% $32) = $52

3

Fixed cost per unit = 25% of manufacturing overhead = 25%

4

$32 = $8

Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of manufacturing overhead = $6 + $20 + (40% $25) = $36

5

Fixed cost per unit in Metals Division = 60% of manufacturing overhead = 60%

$25 = $15

2.

Bonus paid to division managers at 1% of division operating income will be as follows:

Mining Division mana ger’s bonus (1% $6,000,000; 1% $1,200,000) Metals Division manager’ s bonus (1% $1,800,000; 1% $6,600,000)

Method A

Method B

Internal Transfers

Internal Transfers at

at Market Prices

110% of Full Costs

$60,000

$ 12,000

18,000

66,000

The Mining Division manager will prefer Method A (transfer at market prices) because this method gives $60,000 of bonus rather than $12,000 under Method B (transfers at 110% of full costs). The Metals Division manager will prefer Method B because this method gives $66,000 of bonus rather than $18,000 under Method A.

3. Brian Jones, the manager of the Mining Division, will appeal to the existence of a competitive market to price transfers at market prices. Using market prices for transfers in these conditions leads to goal congruence. Division managers acting in their own best interests make decisions that are also in the best interests of the company as a whole. Jones will further argue that setting transfer prices based on cost will cause Jones to pay no attention to controlling costs since all costs incurred will be recovered from the Metals Division at 110% of full costs.