CHAPTER 1: Management Accounting Defined, Described, and Compared to Financial Accounting

MANAGEMENT ACCOUNTING CONCEPTS AND TECHNIQUES

By Dennis Caplan, University at Albany (State University of New York)

CHAPTER 23: Transfer Pricing

Exercises and Problems

23-1: The McNabb Company’s Eastern Division has capacity to produce 200,000 widgets annually. The normal selling price is $19 per widget. Fixed costs are $800,000, and variable costs are $7 per widget. Another division of McNabb Company would like to buy some widgets from the Eastern Division.

Required:

A) Assume the Eastern Division is operating at 100% of capacity (demand from current customers exceeds the Eastern Division's production capacity). The Western Division would like to purchase 10,000 widgets from the Eastern Division, and $2 of the variable costs incurred by the Eastern Division could be avoided on each widget transferred. What is the lowest transfer price the Eastern Division should accept?

B) Assume that the Eastern Division is operating at 80% of capacity. The Western Division would like to purchase 20,000 widgets. No variable cost would be avoided on the sale. What is the lowest transfer price the Eastern Division should accept?

C) Assume the Eastern Division is operating at 95% of capacity. The Western Division would like to buy 40,000 widgets in an all-or-nothing deal (it is 40,000 or zero). There would be no variable cost savings. What is the lowest transfer price the Eastern Division could accept to maintain its current profitability?

23-2: The Upstream Division of CDC makes an intermediate product at a variable cost of $40 per unit, but the cost is $12 less per unit on internal sales, due to reduced packaging requirements. The Division can sell everything it can produce to the outside market for $60 per unit ($60 is the market price for the intermediate product). The Downstream Division can use the intermediate product in its own manufacturing process. Excluding the cost to the Downstream Division of obtaining this intermediate product, its variable production cost is $55 per unit, and it sells its final product for $108 per unit. The Downstream Division can buy the intermediate product from an independent supplier for the market price of $60 per unit. What is the range of transfer prices at which the managers of both divisions would be willing to transfer product?

23-3: The Engineering Department of Electronics Mega-Corporation transferred one of the widgets that it manufactured to the Eastern Division of the company. This transfer occurred using a transfer price of the Engineering Department’s budgeted variable cost of production. The market price of the widget was $105.

The Eastern Division didn’t do any work on the widget, but rather transferred the widget to the Western Division. This transfer occurred using a transfer price of the Engineering Department’s budgeted full cost of production.

The Western Division didn’t do any work on the widget either, but transferred the widget to the Central Division. This transfer occurred using a transfer price of the Engineering Department’s actual full cost of production.

The Central Division didn’t do any work on the widget either, but transferred the widget to the Southern Division. This transfer occurred using a transfer price of the Engineering Department’s actual full cost of production plus a 10% mark-up.

The Southern Division didn’t do any work on the widget, but transferred the widget to the European Division. This transfer occurred using a dual transfer price. The Southern Division received its cost, and the European Division paid the market price.

Following is cost information for the widget and for the Engineering Department.

Budget

Actual

Direct materials per unit

Direct labor hours per unit

Direct labor wage rate per hour

Variable overhead per unit

$10

$50

$12

$50

Fixed and variable overhead are allocated based on direct labor hours. Annual fixed costs for the department were budgeted for $1,000,000, but actual fixed costs were $1,200,000. Total direct labor hours for the department for the year were budgeted for 100,000, but actual labor hours were 80,000.

Required:

A) What is the transfer price from Engineering to the Eastern Division?

B) What is the transfer price from the Eastern Division to the Western Division?

C) What is the transfer price from the Western Division to the Central Division?

D) What is the transfer price from the Central Division to the Southern Division

E) What is the transfer price paid by the European Division for the widget?

23-4: The Olala Juice Company makes and sells apple juice. Olala operates as two divisions: the New York Division under the name “Yo, Juice!”; and the California Division under the name “Wow, Juice?” Each division has a sales department and a production department. Each production department makes the same product: organic, wholesome, pasteurized apple juice. Usually, each division sells the juice that it makes. However, sometimes the New York sales force sells juice to a customer on the West Coast, in which case the most sensible thing to do is to ship the juice out of the California division’s plant, and for purposes of calculating divisional income, transfer the product on paper from the California Division to the New York Division. Similarly, sometimes the California Division sells juice to an East Coast customer. Following is cost and volume information for each division for 2004. No marketing costs are incurred on internal sales.

New York Division California Division

(The “Yo, Juice!” Co.) (The “Wow, Juice?” Co.)

External sales 900 cases at $25 per case 1,300 cases at $25 per case

Manufacturing Costs:

Variable costs $15 per case $12 per case

Fixed costs $5,000 $13,200

Marketing Costs:

Variable Costs $1.00 per case $0.50 per case

Fixed Costs $500 $1,000

Production 1,000 cases 1,200 cases

Transfers

to the other division 200 cases 100 cases

from the other division 100 cases 200 cases

Required:

A) If transfers are made at variable manufacturing cost of the division that produced and transfers the product, calculate the divisional income of each division, using Variable Costing.

B) If transfers are made at full manufacturing cost of the division that produced and transfers the product, calculate the divisional income of each division, using Absorption Costing.

23-5 (Continuation of 23-4): Which of the following will maximize the sum of divisional operating income for the two divisions?

(A) A dual transfer price in which the selling division receives the full (variable plus fixed) manufacturing cost and the buying division pays the market price.

(B) A dual transfer price in which the selling division receives the market price and the buying division pays the full (variable plus fixed) manufacturing cost.

(D) Every transfer price will result in the same total for the sum of the two division’s operating income. The transfer price only affects how this total is allocated between the two divisions.

23-6 (Continuation of 23-4): Assume each division is producing at capacity, and that each division can sell as much product as it produces to external customers at the market price (unlimited demand). Each manager is allowed to decide whether to transfer product to the other division. Which transfer price ensures that each manager is willing to transfer product to the other division?

(A) A dual transfer price in which the selling division receives the full (variable plus fixed) manufacturing cost and the buying division pays the market price.

(B) A dual transfer price in which the selling division receives the market price and the buying division pays the full (variable plus fixed) manufacturing cost.

(D) None of the above.

23-7 (Continuation of 23-4): Assume all of the juice transferred from N.Y. to California is sold before year-end. However, some of the juice transferred from California to N.Y. has not been sold, and is in ending inventory. Which transfer pricing scheme will result in the lowest value for ending inventory for financial reporting of the consolidated company under GAAP?

(A) Variable manufacturing cost plus a 20% mark-up

(B) Full (variable plus fixed) manufacturing cost with no mark-up

(D) Each of the above transfer prices results in the same value for ending inventory

23-8: Robinson Farms has two divisions, the Orchard Division, and the Kitchen Division. The Orchard Division grows apples for a variable cost of $6 per bushel. Its 2005 sales were 150,000 bushels to outsiders at $10 per bushel and 40,000 bushels to the Kitchen Division at 140% of variable costs. Under a dual transfer pricing system, The Kitchen Division pays only the variable cost per bushel. The fixed manufacturing costs of the Orchard Division were $250,000 per year.

The Kitchen Division bakes pies with the apples, and sells the pies to outside customers for $2.00 per pie. It takes one bushel of apples to make a dozen pies. The Kitchen Division has variable manufacturing costs of $0.40 per pie in addition to the costs from the Orchard Division. The annual fixed manufacturing costs of the Kitchen Division were $170,000. There were no beginning inventories or ending inventories during the year.

Required:

A) What is the operating income of the Orchard Division?

B) What is the operating income of the Kitchen Division?

C) What is the operating income of Robinson Farms as a whole?

D) Explain why the company operating income is less than the sum of the two divisions' total income.

E) Now assume that there is no beginning or ending inventory of apples, but that out of the 480,000 pies manufactured, Sunnybrook Kitchen has 60,000 pies unsold at the end of 2005. Ignoring the issue of spoilage (the pies can be frozen), how would this ending inventory be valued for financial reporting purposes (i.e., for G.A.A.P.)? That is, what is the dollar value of this inventory on Robinson's consolidated financial statements?

23-9: The Upstream Division of Consolidated Inc. makes a widget that is transferred to the Downstream Division for further processing and eventual sale to outside customers. In May, the Upstream Division started with zero inventory, made 1,000 widgets, and transferred 800 widgets to the Downstream Division. The total cost to produce these 1,000 widgets was $50,000 in variable manufacturing costs and $100,000 in fixed manufacturing costs. Since the Upstream Division is strictly a manufacturing division, there were no non-manufacturing costs. Although the Upstream Division did not sell any widgets on the open market in May, there is a market for these widgets, and the market price in May was $180 per widget. The Downstream Division processed 750 of the 800 widgets received in May, at a total cost of $120,000 ($80,000 in variable manufacturing costs, and $40,000 in fixed manufacturing costs), and sold 665 of these widgets in May for $400 each. The Downstream Division incurred variable non-manufacturing costs of $10 per unit sold, and fixed non-manufacturing costs of $30,000.

Required:

A) What is the market-based transfer price? Calculate divisional income for the Upstream Division using Absorption Costing and the market-based transfer price.

B) What is the transfer price if product is transferred at variable cost of production? Calculate divisional income for the Upstream Division using Variable Costing and a variable cost-based transfer price.

C) What is the transfer price if the company transfers product at the full (variable plus fixed) cost of production? Calculate divisional income for the Upstream Division using Absorption Costing and a full cost-based transfer price.

D) Calculate divisional income for the Downstream Division using Absorption Costing and a market-based transfer price.

E) Calculate divisional income for the Downstream Division using Absorption Costing and a full cost-based transfer price.

23-10: The Ohio Division of the Chocolate Company makes chocolate, sells some chocolate to candy manufacturers, and transfers the rest of the chocolate to the Ice Cream Division of the Chocolate Company. In January the Ohio Division made 10,000 pounds of chocolate, incurred variable manufacturing costs of $15,000, and fixed manufacturing costs of $10,000. For internal reporting purposes, the company uses a full cost transfer price (i.e., variable plus fixed manufacturing costs) for transfers of product from one division to another. Of the 10,000 pounds of chocolate made in January, 8,000 pounds were sold to other companies at an average sales price of $5 per pound, and 2,000 pounds were transferred to the Ice Cream Division. The Ice Cream division used 1,000 pounds of chocolate to make 10,000 gallons of chocolate ice cream. Additional costs incurred to make the ice cream were $11,000 in variable manufacturing costs and $20,000 in fixed manufacturing costs. All of the ice cream was sold by the end of the month for $5 per gallon, but 1,000 pounds of the chocolate received from the Ohio Division was still on hand at the end of January.

Required:

A) What is the transfer price for January? Calculate divisional Gross Margin using Absorption Costing for the Ohio Division for January.

B) Calculate divisional Gross Margin using Absorption Costing for the Ice Cream Division for January.

C) Now assume the same facts as above, except that instead of using a full cost transfer price, the company uses a market-based transfer price. What is the market-based transfer price? Calculate divisional Gross Margins for both the Ohio Division and the Ice Cream Division using Absorption Costing and the market-based transfer price.

D) Assume the company uses a market-based transfer price for internal reporting purposes. What would the company show for external financial reporting purposes (GAAP) at the end of January for the cost of ending inventory for the chocolate held by the Ice Cream Division?

23-11: The Transylvania Salad Dressing Company operates in two countries: Rumania and Bulgaria. The Rumanian Division has a processing facility that produces olive oil, and also a factory that mixes and bottles salad dressing for the local market. The Bulgarian Division has a processing facility that produces wine vinegar, and also a factory, similar to the Rumanian factory, that mixes and bottles dressing for the local market. Historically, the oil and vinegar processing plants have produced enough oil and vinegar to meet the demand for both the Rumanian and Bulgarian bottling plants, and each processing facility has sold excess product (oil or vinegar) in its local market. Following are relevant data for 2005. All amounts have been translated into U.S. currency.

Rumanian bottling plant

Rumanian oil processing facility

Bulgarian bottling plant

Bulgarian vinegar processing facility

Production (in gallons):

Outside sales (in gallons):

Ending inventory (gallons):

Dressing

Oil

Vinegar

Variable mfg. costs:

Fixed mfg costs:

250,000

$0.36/gal

$100,000

400,000

60,000

$1.00/gal

$300,000

150,000

120,000

30,000

20,000

$0.22/gal

$ 30,000

100,000

20,000

$0.80/gal

$ 50,000

Variable costs of the bottling plants shown above do not include the costs of the vinegar and oil, and are stated as per gallon of finished product (i.e., dressing). All outside sales are made at the prevailing market prices in that country, as shown below.

Market Prices, per gallon:

	In Bulgaria	In Rumania
salad dressing:	$3.00	$3.00
vinegar:	$1.20	$1.40
Oil:	$2.30	$2.00

Additional information: It takes 0.2 gallons vinegar and 0.8 gallons oil to make 1 gallon of salad dressing. The company is based in Bulgaria. The company pays Rumanian taxes on Rumanian income and Bulgarian taxes on consolidated income in excess of Rumanian income. Rumanian income is equivalent to income of the Rumanian division (bottling plant and oil processing plant). The tax rate for the company in Rumania is 50%, and the tax rate for the company in Bulgaria is 40%.

Required:

A) What is the transfer price of oil using variable cost? What is the transfer price of oil using full cost? What is the transfer price of oil using the selling division’s market price?

B) What is the transfer price of vinegar using variable cost? What is the transfer price of vinegar using full cost? What is the transfer price of vinegar using the selling division’s market price?

C) Assume each division buys and sells intermediate product (oil and vinegar) from the other division. What transfer pricing policy (variable cost, full cost, or market price of the selling division) maximizes the company’s after tax profits for the year? The same type of transfer price (variable cost, full cost, or market price) must be used for both vinegar and oil. You may assume that under any transfer pricing method, taxable income in both countries will be positive.

D) Assume the company uses a market-based transfer price for calculating its tax expense. Compute the company’s ending inventory for financial reporting purposes under U.S. Generally Accepted Accounting Principles.

23-12: The dairy in Las Placitas, New Mexico, sells milk, and makes various products from the milk, such as cheese, powdered mild, and Milk Duds. The dairy operates as two divisions: the Cow & Milk Division, and the Advanced Products (A.P.) Division. The manager of the Cow & Milk Division, Beatta Bovine, can choose either to package and sell milk directly to independent customers, or she can sell milk to the manager of the A.P. Division. The manager of the A.P. Division can either buy milk from the Cow & Milk Division, or buy milk on the open market, for use in the production of cheese, butter, etc. Currently, the dairy uses a market-based transfer price for internal sales of milk from one division to the other. Each manager is evaluated based on meeting (or exceeding) divisional profit targets for his or her division.

The manager of the A.P. Division, Hank Holstein, suggests changing to a full cost transfer price with a mark-up. The mark-up would be computed such that if all sales of the Cow & Milk Division were at this price, the Division would just meet its targeted profit amount. Furthermore, Hank suggests allowing his division to buy milk on the open market, but requiring the Cow & Milk Division to sell internally whenever the A.P. Division wants to buy internally. Hank argues that under this new transfer pricing scheme, his division will be no worse off than before (since if the transfer price is above market, he can buy milk on the open market instead of internally), and that the Cow & Milk Division should be satisfied with this transfer price, since internal sales will not pull that Division’s profits below what would be necessary for the Division to meet its targeted profits objective.

Required: Under Hank’s scheme, indicate whether each of the following statements is true or false.

A) If the market demand for milk exceeds the capacity of the Cow & Milk Division, Beatta will never prefer to sell milk to Hank (instead of selling to the open market) when Hank prefers to buy milk from Beatta (instead of buying on the open market).

B) If the Cow & Milk Division has excess capacity relative to market demand, Beatta will always want to supply milk to the Advanced Products Division.

C) This new transfer pricing scheme will ensure that the two divisions will only transfer product when the transfer is in the best interests of the Dairy as a whole.

D) If the Cow & Milk Division can sell all of its production to the Advanced Products division, the new transfer pricing scheme may induce Beatta to relax cost control pertaining to certain divisional costs.

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For a printer-friendly version, contact Dennis Caplan at dcaplan@uamail.albany.edu