Transfer Pricing

PRICING DECISIONS TRUE-FALSE STATEMENTS 1.

In most cases, a company sets the price instead of it being set by the competitive market.

2.

In a competitive market, a company is forced to act as a price taker and must emphasize minimizing and controlling costs.

3.

The difference between the target price and the desired profit is the target cost of the product.

4.

In a competitive environment, the company must set a target cost and a target selling price.

5.

The cost-plus pricing approach establishes a cost base and adds a markup to this base to determine a target selling price.

6.

The cost-plus pricing model gives consideration to the demand side—whether customers will pay the target selling price.

7.

Sales volume plays a large role in determining per unit costs in the cost-plus pricing approach.

8.

In time and material pricing, the material charge is based on the cost of direct materials used and a material loading charge for related overhead costs.

9.

The first step for time and material pricing is to calculate the material loading charge.

10.

The material loading charge is expressed as a percentage of the total estimated costs of materials for the year.

11.

Divisions within vertically integrated companies normally sell goods only to other divisions within the same company.

12.

Using the negotiated transfer pricing approach, a minimum transfer price is established by the selling division.

13.

There are two approaches for determining a transfer price: cost-based and market-based.

14.

If a cost-based transfer price is used, the transfer price must be based on variable cost.

15.

A problem with a cost-based transfer price is that it does not provide adequate incentive for the selling division to control costs.

16.

In the formula for a minimum transfer price, opportunity cost is the contribution margin of goods sold externally.

17.

The market-based transfer price approach produces a higher total contribution margin to the company than the cost-based approach.

18.

A negotiated transfer price should be used when an outside market for the goods does not exist.

19.

The number of transfers between divisions that are located in different countries has decreased as companies rely more on outsourcing.

20.

Differences in tax rates between countries can complicate the determination of the appropriate transfer price.

*21.

The absorption cost approach is consistent with generally accepted accounting principles because it defines the cost base as the manufacturing cost.

*22.

The first step in the absorption cost approach is to compute the markup percentage used in setting the target selling price.

*23.

Because absorption cost data already exists in general ledger accounts, it is cost effective to use it for pricing.

*24.

The markup percentage in the contribution approach is computed by dividing the desired ROI/unit plus fixed costs/unit by the variable costs/unit.

*25.

Under the contribution approach, the cost base consists of all of the variable costs associated with a product except variable selling and administrative costs.

Answers to True-False Statements Item

1. 2. 3. 4. 5.

Ans.

F T T F T

Item

6. 7. 8. 9. 10.

Ans.

F T T F T

Item

11. 12. 13. 14. 15.

Ans.

F T F F T

Item

16. 17. 18. 19. 20.

Ans.

T F T F T

Item

*21. *22. *23. *24. *25.

Ans.

T F T T F

MULTIPLE CHOICE QUESTIONS 26.

Factors that can affect pricing decisions include all of the following except a. cost considerations. b. environment. c. pricing objectives. d. all of these are factors.

27.

In most cases, prices are set by the a. customers. b. competitive market. c. largest competitor. d. selling company.

28.

A company must price its product to cover its costs and earn a reasonable profit in a. all cases. b. its early years. c. the long run. d. the short run.

29.

Prices are set by the competitive market when a. the product is specially made for a customer. b. there are no other producers capable of manufacturing a similar item. c. a company can effectively differentiate its product from others. d. a product is not easily distinguished from competing products.

30.

All of the following are correct statements about the target price except it a. is the price the company believes would place it in the optimal position for its target audience. b. is used to determine a product's target cost. c. is determined after the company has identified its market and does market research. d. is determined after the company sets its desired profit amount.

31.

In cost-plus pricing, the target selling price is computed as a. variable cost per unit + desired ROI per unit. b. fixed cost per unit + desired ROI per unit. c. total unit cost + desired ROI per unit. d. variable cost per unit + fixed manufacturing cost per unit + desired ROI per unit.

32.

In cost-plus pricing, the markup percentage is computed by dividing the desired ROI per unit by the a. fixed cost per unit. b. total cost per unit. c. total manufacturing cost per unit. d. variable cost per unit.

33.

The cost-plus pricing approach's major advantage is a. it considers customer demand. b. that sales volume has no effect on per unit costs. c. it is simple to compute. d. none of these.

34.

The following per unit information is available for a new product of Riley Company: Desired ROI Fixed cost Variable cost Total cost Selling price

$ 24 40 60 100 124

Riley Company's markup percentage would be a. 19%. b. 24%. c. 40%. d. 60%. 35.

Wenger Company has just developed a new product. The following data is available for this product: Desired ROI per unit Fixed cost per unit Variable cost per unit Total cost per unit

$18 30 45 75

The target selling price for this product is a. $93. b. $75. c. $63. d. $48. 36.

All of the following are correct statements about the cost-plus pricing approach except that it a. is simple to compute. b. considers customer demand. c. includes only variable costs in the cost base. d. will only work when the company sells the quantity it budgeted.

37.

In the cost-plus pricing approach, the desired ROI per unit is computed by multiplying the ROI percentage by a. fixed costs. b. total assets. c. total costs. d. variable costs.

Use the following information for questions 38-39. Downing Company produces a high resolution computer monitor. The following information is available for this product: Fixed cost per unit Variable cost per unit Total cost per unit Desired ROI per unit 38.

Downing Company's markup percentage would be a. 120%. b. 60%. c. 40%.

$ 50 150 200 60

39.

d. 30%. The target selling price for this monitor is a. $110. b. $200. c. $210. d. $260.

40.

In time and material pricing, a material loading charge covers all of the following except a. purchasing costs. b. related overhead. c. desired profit margin. d. all of these are covered.

41.

The first step for time and material pricing is to calculate the a. charge for obtaining materials. b. charge for holding materials. c. labor charge per hour. d. charges for a particular job.

42.

The labor charge per hour in time and material pricing includes all of the following except a. an allowance for a desired profit. b. charges for labor loading. c. selling and administrative costs. d. overhead costs.

43.

The last step in determining the material loading charge percentage is to a. estimate annual costs for purchasing, receiving, and storing materials. b. estimate the total cost of parts and materials. c. divide material charges by the total estimated costs of parts and materials. d. add a desired profit margin on the materials themselves.

44.

In time and material pricing, the charge for a particular job is the sum of the labor charge and the a. materials charge. b. material loading charge. c. materials charge + desired profit. d. materials charge + the material loading charge.

Use the following information for questions 45-47. The following data is available for Computer Bytes Repair Shop for 2003: Repair technician's wages Fringe benefits Overhead Total

$ 90,000 20,000 15,000 $125,000

The desired profit margin is $10 per labor hour. The material loading charge is 40% of invoice cost. It is estimated that 5,000 labor hours will be worked in 2003. 45.

Computer Bytes’ labor charge in 2003 would be a. $25. b. $28. c. $32.

46.

d. $35. In January 2003, Computer Bytes repairs a computer that uses parts of $80. Its material loading charge on this repair would be a. $32. b. $48. c. $80. d. $112.

47.

In March 2003, Computer Bytes repairs a computer that takes two hours to repair and uses parts of $60. The bill for this computer repair would be a. $130. b. $140. c. $148. d. $154.

48.

Negotiated transfer pricing is not always used because of each of the following reasons except that a. market price information is sometimes not easily obtainable. b. a lack of trust between the negotiating divisions may lead to a breakdown in the negotiations. c. negotiations often lead to different pricing strategies from division to division. d. opportunity cost is sometimes not determinable.

49.

All of the following are approaches for determining a transfer price except the a. cost-based approach. b. market-based approach. c. negotiated approach. d. time and material approach.

50.

When a cost-based transfer price is used, the transfer price may be based on any of the following except a. fixed cost. b. full cost. c. variable cost. d. all of these may be used.

51.

All of the following are correct statements about the cost-based transfer price approach except that it a. can understate the actual contribution to profit by the selling division. b. can reduce a division manager's control over the division's performance. c. bases the transfer price on standard cost instead of actual cost. d. provides incentive for the selling division to control costs.

52.

The general formula for the minimum transfer price is: minimum transfer price equals a. fixed cost + opportunity cost. b. external purchase price. c. total cost + opportunity cost. d. variable cost + opportunity cost.

53. a. b. c. d.

Variable costs of units sold internally will always be lower than the variable costs of units sold externally. higher than the variable costs of units sold externally. the same as the variable costs of units sold externally. Variable costs of units sold internally may be either higher or lower than for units sold externally.

54.

In the formula for the minimum transfer price, opportunity cost is the __________ of the goods sold externally. a. variable cost b. total cost c. selling price d. contribution margin

55.

The transfer price approach that conceptually should work the best is the a. cost-based approach. b. market-based approach. c. negotiated price approach. d. time and material pricing approach.

56.

The transfer price approach that is often considered the best approach because it generally provides the proper economic incentives is the a. cost-based approach. b. market-based approach. c. negotiated price approach. d. time and material pricing approach.

57.

All of the following are correct statements about the market-based approach except that it a. assumes that the transfer price should be based on the most objective inputs possible. b. provides a fairer allocation of the company's contribution margin to each division. c. produces a higher company contribution margin than the cost-based approach. d. ensures that each division manager is properly motivated and rewarded.

58.

The negotiated transfer price approach should be used when a. the selling division has available capacity and is willing to accept less than the market price. b. an outside market for the goods does not exist. c. no market price is available. d. any of these situations exist.

59.

Assuming the selling division has available capacity, a negotiated transfer price should be within the range of a. fixed cost per unit and the external purchase price. b. total cost per unit and the external purchase price. c. variable cost per unit and the external purchase price. d. none of these is correct.

60.

The transfer price approach that will result in the largest contribution margin to the buying division is the a. cost-based approach. b. market-based approach. c. negotiated price approach.

61.

d. time and material pricing approach. The maximum transfer price from the buying division's standpoint is the a. total cost + opportunity cost. b. variable cost + opportunity cost. c. external purchase price. d. external purchase price + opportunity cost.

Use the following information for questions 62-63. The Rubber Division of Morgan Company manufactures rubber moldings and sells them externally for $50. Its variable cost is $20 per unit, and its fixed cost per unit is $7. Morgan's president wants the Rubber Division to transfer 5,000 units to another company division at a price of $27. 62.

Assuming the Rubber Division has available capacity of 5,000 units, the minimum transfer price it should accept is a. $7. b. $20. c. $27. d. $50.

63.

Assuming the Rubber Division does not have any available capacity, the minimum transfer price it should accept is a. $7. b. $20. c. $27. d. $50.

64.

All of the following are correct statements about transfers between divisions located in countries with different tax rates except that a. differences in tax rates across countries complicate the determination of the appro-priate transfer price. b. many companies prefer to report more income in countries with low tax rates. c. companies must pay income tax in the country where income is generated. d. a decreasing number of transfers are between divisions located in different countries.

65.

Transfers between divisions located in countries with different tax rates a. simplify the determination of the appropriate transfer price. b. are decreasing in number as more companies "localize" operations. c. encourage companies to report more income in countries with low tax rates. d. all of these are correct.

*66.

Which of the following is consistent with generally accepted accounting principles? a. Absorption cost approach b. Contribution approach c. Variable-cost approach d. Both absorption cost and contribution approach

*67.

Under the absorption cost approach, all of the following are included in the cost base except a. direct materials. b. fixed manufacturing overhead. c. selling and administrative costs. d. variable manufacturing overhead.

*68.

The first step in the absorption cost approach is to compute the a. desired ROI per unit. b. markup percentage. c. target selling price. d. unit manufacturing cost.

*69.

The markup percentage in the absorption cost approach is computed by dividing the sum of the desired ROI per unit and a. fixed costs per unit by manufacturing cost per unit. b. fixed costs per unit by variable costs per unit. c. selling and administrative expenses per unit by manufacturing cost per unit. d. selling and administrative expenses per unit by variable costs per unit.

*70.

In the absorption cost approach, the markup percentage covers the a. desired ROI only. b. desired ROI and selling and administrative expenses. c. desired ROI and fixed costs. d. selling and administrative expenses only.

*71.

The absorption cost approach is used by most companies for all of the following reasons except that a. absorption cost information is readily provided by a company's cost accounting system. b. absorption cost provides the most defensible bases for justifying prices to interested parties. c. basing prices on only variable costs could encourage managers to set too low a price to boost sales. d. this approach is more consistent with cost-volume-profit analysis.

*72.

Under the contribution approach, the cost base includes all of the following except a. fixed manufacturing costs. b. variable manufacturing costs. c. total fixed costs. d. variable selling and administrative costs.

*73.

In the contribution approach, the markup percentage covers the a. desired ROI only. b. desired ROI and fixed costs. c. desired ROI and selling and administrative expenses. d. fixed costs only.

*74.

The markup percentage denominator in the contribution approach is the a. desired ROI per unit. b. fixed costs per unit. c. manufacturing cost per unit. d. variable costs per unit.

*75.

The reasons for using the contribution approach include all of the following except this approach a. avoids arbitrary allocation of common fixed costs to individual product lines. b. is more consistent with cost-volume-profit analysis. c. provides the most defensible bases for justifying prices to all interested parties. d. provides the type of data managers need for pricing special orders.

Answers to Multiple Choice Questions Item

26. 27. 28. 29. 30. 31. 32. 33.

Ans.

d b c d d c b c

Item

34. 35. 36. 37. 38. 39. 40. 41.

Ans.

b a c b d d d c

Item

42. 43. 44. 45. 46. 47. 48. 49.

Ans.

b d d d a d d d

Item

50. 51. 52. 53. 54. 55. 56. 57.

Ans.

Item

a d d d d c b c

Ans.

58. 59. 60. 61. 62. 63. 64. 65.

d c a c b d d c

Item

*66. *67. *68. *69. *70. *71. *72. *73.

Ans.

a c d c b d c b

Item

*74. *75.

Ans.

d c

EXERCISES Ex. 76 Sole Company is considering introducing a new line of hand-held organizers targeting the preteen population. Sole believes that if the organizers can be priced competitively at $90, approximately 500,000 units can be sold. The controller has determined that an investment in new equipment totaling $8,000,000 will be required. Sole requires a minimum rate of return of 14% on all investments. Instructions Compute the target cost per unit of the handheld organizer.

Solution 76

(6-10 min.)

Sales (500,000 × $90) Less desired ROI ($8,000,000 × 14%) Target cost for 500,000 units

$45,000,000 1,120,000 $43,880,000

Target cost per unit = $43,880,000 ÷ 500,000 = $87.76

Ex. 77 Carter Corporation produces window air conditioners. The following information is available for Carter's anticipated annual volume of 400,000 units. Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling and administrative expenses Fixed selling and administrative expenses

Per Unit $21 27 36

Total

$6,000,000 42 3,600,000

The company has a desired ROI of 25%. It has invested assets of $72,000,000. Ex. 77 (cont.) Instructions Compute each of the following: 1. Total cost per unit. 2. Desired ROI per unit. 3. Markup percentage using total cost per unit. 4. Target selling price.

Solution 77

(12 min.)

1. Total cost per unit: Per Unit $ 21 27 36 15 42 9 $150

Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($6,000,000 ÷ 400,000 Variable selling and administrative expenses Fixed selling and administrative expenses ($3,600,000 ÷ 400,000) 2. Desired ROI per unit = (25% × $72,000,000) ÷ 400,000 = $45 3. Markup percentage using total cost per unit =

$45 + $0 ———— = 30% $150

4. Target selling price = $150 + ($150 × 30%) = $195

Ex. 78 Barkley Corporation is in the process of setting a selling price for a new product it has just designed. The following data relate to this product for a budgeted volume of 60,000 units. Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling and administrative expenses Fixed selling and administrative expenses

Per Unit $10 20 5

Total

$900,000 3 540,000

Barkley uses cost-plus pricing to set its target selling price. The markup on total unit cost is 25%. Instructions Compute each of the following for the new product:

1. Total variable cost per unit, total fixed cost per unit, and total cost per unit. 2. Desired ROI per unit. 3. Target selling price. Solution 78

(18 min.)

1. Direct materials Direct labor Variable manufacturing overhead Variable selling and administrative expenses Variable cost per unit

Fixed manufacturing overhead Fixed selling and administrative expenses Fixed cost per unit Variable cost per unit Fixed cost per unit Total cost per unit

$10 20 5 3 $38 Total Costs $900,000 540,000

Budgeted Volume ÷ 60,000 ÷ 60,000

Cost Per Unit = $15 = 9 $24

$38 24 $62

2. Total cost per unit Markup Desired ROI per unit

$62 × 25% $15.50

3. Total cost per unit Desired ROI per unit Target selling price

$62.00 15.50 $77.50

Ex. 79 Whiz-by Company is in the process of setting a selling price for its newest model scooter, the Zip. The controller of Whiz-by estimates variable cost per unit for the new model to be as follows: Direct materials Direct labor Variable manufacturing overhead Variable selling and administrative expenses

$30 26 8 10 $74

In addition, Whiz-by anticipates incurring the following fixed cost per unit at a budgeted sales volume of 20,000 units: Total Costs ÷ Budget Volume = Cost per Unit Fixed manufacturing overhead $480,000 20,000 $24 Fixed selling and administrative expenses 520,000 20,000 26 Fixed cost per unit $50 Whiz-by uses cost-plus pricing and would like to earn a 12 percent return on its investment (ROI) of

$500,000. Instructions Compute the selling price that would provide Whiz-by a 12 percent ROI.

Solution 79

(6 - 10 min.) Variable cost per unit Fixed cost per unit Desired ROI per unit Target selling price

$ 74 50 3* $127

*$50,000 × .12 = $60,000; $60,000 ÷ 20,000 = $3 per unit

Ex. 80 Sparks Engine Service repairs and rebuilds diesel engines. The following budgeted cost data is available for 2003:

Technicians' wages and benefits Parts manager's salary and benefits Office manager's salary and benefits Other overhead Total budgeted costs

Time Charges $300,000 56,000 24,000 $380,000

Material Charges $ 36,000 9,000 55,000 $100,000

Sparks has budgeted for 10,000 hours of technician time during the coming year. It desires a $32 profit margin per hour of labor and a 50% profit margin on parts. Sparks estimates the total invoice cost of parts and materials in 2003 will be $500,000. Instructions 1. Compute the rate charged per hour of labor. 2. Compute the material loading charge. 3. Sparks has received a request from Mercer Corporation for an estimate to rebuild a diesel engine. The company estimates that it would take 20 hours of labor and $4,000 of parts. Compute the total estimated bill.

Solution 80

(18-20 min.)

1. Total Cost Hourly labor rate for repairs Technicians' wages and benefits Overhead costs Office manager's salary and benefits Other overhead Profit margin Rate charged per hour of labor

Per Hour Charge

Total Hours

$300,000

÷

10,000

=

$30.00

56,000 24,000 $380,000

÷ ÷ ÷

10,000 10,000 10,000

= = =

5.60 2.40 38.00 32.00 $70.00

Solution 80 2.

(cont.)

Charges Overhead costs Parts manager's salary and benefits Office manager's salary and benefits Other overhead

Material Material Total Invoice Cost, Loading Parts and Materials Charge $36,000 9,000 $45,000 55,000

÷ ÷

$500,000 $500,000

20% Profit margin Material loading charge

= =

9% 11% 50% 70%

3. Job: Mercer Corporation Labor charges 20 hours @ $70 Material charges Cost of parts and materials Material loading charge (70% × $4,000) Total price of labor and materials

$1,400 $4,000 2,800

6,800 $8,200

Ex. 81 Frank's Transmission Service has budgeted the following time and material for 2002: BUDGETED COSTS FOR 2002

Mechanics' wages and benefits Service manager's salary and benefits Office employee's salary and benefits Cost of parts used Overhead (supplies, utilities, etc.) Total budgeted costs

Time Charges $ 72,000 24,000 20,000 $116,000

Material Charges $ 42,000 6,000 100,000 17,000 $165,000

Frank budgets 4,000 hours of repair time in 2002 and will charge a profit of $6 per hour, in addition to a 25% markup on the cost of parts. On February 15, 2002, Frank is asked to prepare a price estimate to rebuild the transmission in a 1997 Lincoln Navigator. Frank estimates that this job will take 12 labor hours and $300 in parts. Instructions 1. Compute the labor rate for 2002. 2. Compute the material loading charge rate for 2002. 3. Prepare a time and materials price estimate for rebuilding the Navigator transmission.

Solution 81

(18-20 min.)

1. Computation of labor rate Total Cost Hourly labor rate for repairs Mechanics' wages and benefits Overhead costs Office employee's salary and benefits Other overhead

Total Hours

Per Hour Charge

$ 72,000

÷

4,000

=

$18

24,000 20,000 $116,000

÷ ÷ ÷

4,000 4,000 4,000

= = =

6 5 29 6 $35

Profit margin Rate charged per hour of labor 2. Computation of material loading charge Material Charges Overhead costs Service manager's salary and benefits Office employee's salary and benefits 48,000 Other overhead

$42,000 6,000 ÷ 17,000 $65,000

Material Loading Charge

Total Invoice Cost, Parts and Materials

$100,000 = ÷ 100,000 ÷ 100,000

Profit margin Material loading charge

48% = =

17% 65% 25% 90%

3. Price estimate for time and materials Job: Rebuild Navigator transmission Labor charges: 12 hours @ $35 Material charges Cost of parts and materials Material loading charge (90% × $300) Total price of labor and materials

$420 $300 270

570 $990

Ex. 82 Mathis Corporation manufactures automotive compact disc changers. It is a division of American Motors, which manufactures automobiles. Mathis sells the CD changers to American, as well as to retail stores. The following information is available for Mathis's CD changer: variable cost per unit $105; fixed costs per unit $75; and a selling price of $260 to outside customers. American currently purchases CD changers from an outside supplier for $240 each. Top management of American would like Mathis to provide 50,000 changers per year at a transfer price of $105 each. Instructions

Compute the minimum transfer price that Mathis should accept under each of the following assumptions: 1. Mathis is operating at full capacity. 2. Mathis has sufficient excess capacity to provide the 50,000 changers to American. Solution 82

(9 min.)

1. The minimum transfer price is $260 [$105 + ($260 – $105)], the outside market price, since Mathis is operating at full capacity. 2. The minimum transfer price is $105, the variable cost of the changers, since Mathis has excess capacity. However, since the market price is $240 (American's current cost), Mathis should be able to negotiate a price much higher than $105.

Ex. 83 Modine Manufacturing, a division of Datson Corporation, produces car radiators. Modine sells radiators to auto parts stores, as well as to Datson. The following information is available for Modine's radiators: Fixed costs per unit Variable cost per unit Selling price per unit

$ 90 60 215

Datson can purchase comparable radiators from an outside supplier for $200. In order to ensure a reliable supply, Datson's management ordered Modine to provide 100,000 radiators per year at a transfer price of $200 per unit. Modine is currently operating at full capacity. It could avoid $4 per unit of variable selling costs by selling internally. Instructions 1. Compute the minimum transfer price that Modine should be required to accept. 2. Compute the increase (decrease) in contribution margin for Datson for this transfer.

Solution 83

(9 min.)

1. The minimum transfer price that Modine should accept is: ($60 – $4 + ($215 – $60) = $211 2. The decrease in contribution margin per unit to Datson is: Contribution margin lost by Modine ($215 – $60) Increased contribution margin to vehicle division ($200 – $56) Net decrease in contribution margin Total contribution margin decrease is: $11 × 100,000 units = $1,100,000

$155 144 $ 11

Ex. 84 Allcell Manufacturing is a division of Birch Communications, Inc. Allcell produces cell phones and sells these phones to other communication companies, as well as to Birch. Recently, the vice president of marketing for Birch approached Allcell with a request to make 20,000 units of a special cell phone that could be used anywhere in the world. The following information is available regarding the Allcell division: Selling price of regular cell phone Variable cost of regular cell phone Additional variable cost of special cell phone

$80 45 30

Instructions Calculate the minimum transfer price and indicate whether the internal transfer should occur for each of the following: 1. The marketing vice president offers to pay Allcell $95 per phone. Allcell has available capacity. 2. The marketing vice president offers to pay Allcell $95 per phone. Allcell has no available capacity and would have to forgo sales of 20,000 phones to existing customers to meet this request. 3. The marketing vice president offers to pay Allcell $145 per phone. Allcell has no available capacity and would have to forgo sales of 30,000 phones to existing customers to meet this request.

Solution 84

(13 min.)

1. Assuming that Allcell Manufacturing has available capacity, variable cost would be ($45 + $30) or $75 and the opportunity cost would be zero. Therefore, the minimum transfer price would be $75 = $75 + $0. Since the $95 transfer price being offered exceeds the $75 minimum transfer price, the offer should be accepted. 2. Assuming no available capacity, and that the new units produced would be equal to the number of standard units forgone, variable cost of the special cell phone would be ($45 + $30) or $75 and the opportunity cost would be ($80 - $45) or $35. Therefore, the minimum transfer price would be $110 = $75 + $35. Since this is higher than the $95 transfer price, Allcell Manufacturing should reject the offer. 3. Assuming no available capacity, and that in order to produce the 20,000 special cell phones, 30,000 standard cell phones would be forgone, the minimum variable cost would be ($45 + $30) or $75 and the opportunity cost would be: Total contribution margin on standard cell phones ($80 – $45) × 30,000 —————————————————————— = —————————— = $52.50 Number of special cell phones $20,000 Therefore, the minimum transfer price would be $127.50 = ($45 + $30) + $52.50. Since the $145 transfer price being offered exceeds the minimum transfer price of $127.50, Allcell Manufacturing should accept the offer.

Ex. 85 Pubworld is a textbook publishing company that has contracts with several different authors. It also

operates a printing operation called Printpro. Both companies operate as separate profit centers. Printpro prints textbooks written by Pubworld authors, as well as books written by non-Pubworld authors. The printing operation bills out at $0.02 per page and a typical textbook requires 600 pages of print. A developmental editor from Pubworld approached the printing operation manager offering to pay $0.012 per page for 5,000 copies of a 600-page textbook. Outside printers are currently charging $0.015 per page. Printpro's variable cost per page is $0.01. Instructions 1. Calculate the appropriate transfer price and indicate whether the printing should be done internally by Printpro under each of the following situations: a. Printpro has available capacity. b. Printpro has no available capacity and would have to cancel an outside customer's job to accept the editor's offer. 2. Calculate the change in contribution margin for each company, if top management forces Printpro to accept the $0.012 transfer price when it has no available capacity.

Solution 85

(13 min.)

1a. Assuming that the printing operation has available capacity, the printing operation's variable cost is $0.01 and its opportunity cost is $0. The minimum transfer price would be $0.01 = $0.01 + $0. Therefore, in this case, the printing operation should accept the offer to print internally. The $0.012 transfer price would provide a contribution margin of ($0.012 - $0.01) or $0.002 per page. Depending on its bargaining strength, the printing operation might want to ask for a transfer price higher than $0.012, since the company is saving money at any price below the $0.015 price charged by outside printers. 1b. Assuming no available capacity, the printing operation's variable cost is $0.01 per page and its opportunity cost is ($0.02 – $0.01) or $0.01 per page. The minimum transfer price would be $0.02 = $0.01 + $0.01. Therefore, the printing would not accept the internal transfer price of $0.012. 2. Printpro would lose: ($0.02 - $0.01) × 600 pages × 5,000 copies = $30,000 Pubworld would save: ($0.015 – $0.012) × 600 pages × 5,000 copies = $9,000

*Ex. 86 The following information is available for a product manufactured by Wilson Corporation: Per Unit $125 95 30

Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead Variable selling and admin. expenses Fixed selling and admin. expenses

Total

$500,000 20 110,000

Wilson has a desired ROI of 16%. It has invested assets of $16,500,000 and expects to produce 2,000 units per year. Instructions Compute each of the following: 1. Cost per unit of fixed manufacturing overhead and fixed selling and administrative expenses. 2. Desired ROI per unit. 3. Markup percentage using the absorption cost approach. 4. Markup percentage using the contribution approach.

*Solution 86

(12-14 min.)

1. Fixed manufacturing overhead =

$500,000 per unit ———————— = $250 per unit 2,000

Fixed selling and administrative expenses per unit =

2. Desired ROI per unit =

$110,000 ———— = $55 per unit 2,000

16% × $16,500,000 ————————— = $1,320 per unit 2,000

3. Absorption cost markup percentage = $125 + $95 + $30 + $250 4. Contribution markup percentage =

$1,320 + ($20 + $55) ——————————— = 279% $1,320 + ($250 + $55) ——————————— = 602% $125 + $95 + $30 + $20

*Ex. 87 Peachtree Doors, Inc. is in the process of setting a target price on its newly designed patio door. Cost data relating to the door at a budgeted volume of 5,000 units is as follows: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead

Per Unit $250 170 80

Total

$500,000

Variable selling and administrative expenses Fixed selling and administrative expenses

25 375,000

*Ex. 87 (cont.) Peachtree uses cost-plus pricing that provides it with a 25% ROI on its patio door line. A total of $4,000,000 in assets is committed to production of the new door. Instructions 1. Compute each of the following under the absorption approach: a. Markup percentage needed to provide desired ROI. b. Target price of the patio door. 2. Compute each of the following under the contribution approach: a. Markup percentage needed to provide desired ROI. b. Target price of the patio door.

*Solution 87

(12-14 min.)

1. Absorption approach a. Computation of unit manufacturing cost: Direct materials Direct labor Variable manufacturing overhead Fixed manufacturing overhead ($500,000 ÷ 5,000) Total manufacturing cost

Per Unit $250 170 80 100 $600

Computation of markup percentage to provide a 25% ROI: Markup [25% × ($4,000,000 ÷ 5,000)] + [$25 + ($375,000 ÷ 5,000)] Percentage = —————————————————————————— = $600

$300 —— = 50% $600

b. Computation of target price: Target price: $600 + (50% × $600) = $900 2. Contribution approach a. Computation of unit variable cost: Direct materials Direct labor Variable manufacturing overhead Variable selling and administrative expenses Total variable cost

Per Unit $250 170 80 25 $525

Computation of markup percentage to provide a 25% ROI: Markup [25% × ($4,000,000 ÷ 5,000)] + [($500,000 ÷ 5,000) + ($375,000 ÷ 5,000)] Percentage = ————————————————————————————————— $525

$375 = —— = 71.429% $525 b. Computation of target price: Target price: $525 + (71.429% × $525) = $900

COMPLETION STATEMENTS 88.

The difference between the target price and the desired profit is the _________________ cost of the product.

89.

In the cost-plus pricing formula, the target selling price equals cost + (________________ × cost).

90.

The _______________ pricing approach has a major advantage: it is simple to compute.

91.

Under the time and material pricing approach, the material charge is based on the cost of direct materials used and a material __________________ for related overhead costs.

92.

The transfer of goods between divisions of the same company is termed _____________ sales.

93.

The three approaches for determining a transfer price are negotiated, ________________ based, and _________________ based transfer prices.

94.

To ensure that the selling division attempts to control its costs, the transfer price should be based on _________________ cost instead of actual cost.

95.

The formula for the minimum transfer price is: Minimum transfer price = Variable cost + ___________________.

96.

__________________ involves contracting with an external party to provide a good or service, rather than performing the work internally.

97.

The __________________ approach is consistent with generally accepted accounting principles because it defines the cost base as the manufacturing cost.

Answers to Completion Statements 88. 89. 90. 91. 92.

target markup percentage cost-plus loading charge internal

93. 94. 95. 96. 97.

cost, market standard Opportunity cost Outsourcing absorption cost

MATCHING 98.

Match the items in the two columns below by entering the appropriate code letter in the space provided. A. B. C. D.

Cost-plus pricing Market-based transfer price Markup Negotiated transfer price

E. F. G. H.

Outsourcing Target selling price Time and material pricing Virtual companies

____

1. Contracting with an external party to provide a good or service.

____

2. An approach to cost-plus pricing that uses two pricing rates.

____

3. Product's selling price is determined by adding a markup to a cost base.

____

4. Transfer price is determined by agreement of division managers.

____

5. Companies that have no manufacturing facilities.

____

6. Percentage applied to a product's cost.

____

7. Price that will provide the desired profit on a product.

____

8. Transfer price is based on existing prices of competing products.

Answers to Matching 1. 2. 3. 4.

E G A D

5. 6. 7. 8.

H C F B

SHORT-ANSWER ESSAY QUESTIONS S-A E 99 A variation on cost-plus pricing is time and material pricing. Under this approach, two pricing rates are set. Required: Explain where this approach is used and identify the steps involved in time and material pricing. Also explain what the material loading charge covers and how it is expressed.

Solution 99 The time and material pricing approach is used often in service industries, especially professional firms and consulting firms. This approach involves three steps: (1) calculate the labor charge per hour, (2) calculate the charge for obtaining and holding materials, and (3) calculate the charges for a particular job. The material loading charge covers the costs of purchasing, handling, and storing materials, plus any desired profit margin on the materials. It is expressed as a percentage of the total estimated costs of parts and materials.

S-A E 100 There are three possible approaches for determining a transfer price: negotiated, cost-based, and marketbased transfer prices. Required: Explain how the transfer price is determined under each of the approaches.

Solution 100 Under the negotiated transfer price approach, the transfer price will range between the external purchase price per unit and the sum of unit variable cost and unit opportunity cost. In the cost-based approach, the transfer price is based on either the full cost or the variable cost of the selling division. Under the marketbased approach, the minimum transfer price is the unit variable cost plus the unit opportunity cost.