This textbook is available at## Cornerstones of Cost Management (4th Edition)

Book Edition | 4th Edition |

Author(s) | Hansen, Mowen |

ISBN | 9781305970663 |

Publisher | Cengage |

Subject | Management |

DISCUSSION QUESTIONS

Exercises

Problems

CYBER-RESEARCH CASE

Chapter 10, End Of Chapter, REVIEW PROBLEMS, Exercise I

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**Transfer Pricing**

The Components Division produces a part that is used by the Goods Division. The cost of manufacturing the part is as follows:

Direct materials | $10 |

Direct labor | 2 |

Variable overhead | 3 |

Fixed overhead* | 5 |

Total cost | $20 |

*Based on a practical volume of 200,000 parts.

Other costs incurred by the Components Division are as follows:

Fixed selling and administrative expense | $500,000 |

Variable selling expense | $1 per unit |

The part usually sells for between $28 and $30 in the external market. Currently, the Components Division is selling it to external customers for $29. The division is capable of producing 200,000 units of the part per year; however, because of a weak economy, only 150,000 parts are expected to be sold during the coming year. The variable selling expenses are avoidable if the part is sold internally.

The Goods Division has been buying the same part from an external supplier for $28. It expects to use 50,000 units of the part during the coming year. The manager of the Goods Division has offered to buy 50,000 units from the Components Division for $18 per unit.

**Required:**

Determine the minimum transfer price that the Components Division would accept.

**Transfer Pricing**

The Components Division produces a part that is used by the Goods Division. The cost of manufacturing the part is as follows:

Direct materials | $10 |

Direct labor | 2 |

Variable overhead | 3 |

Fixed overhead* | 5 |

Total cost | $20 |

*Based on a practical volume of 200,000 parts.

Other costs incurred by the Components Division are as follows:

Fixed selling and administrative expense | $500,000 |

Variable selling expense | $1 per unit |

The part usually sells for between $28 and $30 in the external market. Currently, the Components Division is selling it to external customers for $29. The division is capable of producing 200,000 units of the part per year; however, because of a weak economy, only 150,000 parts are expected to be sold during the coming year. The variable selling expenses are avoidable if the part is sold internally.

The Goods Division has been buying the same part from an external supplier for $28. It expects to use 50,000 units of the part during the coming year. The manager of the Goods Division has offered to buy 50,000 units from the Components Division for $18 per unit.

**Required:**

Determine the maximum transfer price that the manager of the Goods Division would pay.

**Transfer Pricing**

The Components Division produces a part that is used by the Goods Division. The cost of manufacturing the part is as follows:

Direct materials | $10 |

Direct labor | 2 |

Variable overhead | 3 |

Fixed overhead* | 5 |

Total cost | $20 |

*Based on a practical volume of 200,000 parts.

Other costs incurred by the Components Division are as follows:

Fixed selling and administrative expense | $500,000 |

Variable selling expense | $1 per unit |

The part usually sells for between $28 and $30 in the external market. Currently, the Components Division is selling it to external customers for $29. The division is capable of producing 200,000 units of the part per year; however, because of a weak economy, only 150,000 parts are expected to be sold during the coming year. The variable selling expenses are avoidable if the part is sold internally.

The Goods Division has been buying the same part from an external supplier for $28. It expects to use 50,000 units of the part during the coming year. The manager of the Goods Division has offered to buy 50,000 units from the Components Division for $18 per unit.

**Required:**

Should an internal transfer take place? Why or why not? If you were the manager of the Components Division, would you sell the 50,000 components for $18 each? Explain.

**Transfer Pricing**

Direct materials | $10 |

Direct labor | 2 |

Variable overhead | 3 |

Fixed overhead* | 5 |

Total cost | $20 |

*Based on a practical volume of 200,000 parts.

Other costs incurred by the Components Division are as follows:

Fixed selling and administrative expense | $500,000 |

Variable selling expense | $1 per unit |

**Required:**

Suppose that the average operating assets of the Components Division total $10 million. Compute the ROI for the coming year, assuming that the 50,000 units are transferred to the Goods Division for $21 each.

Components Division has spare capacity equal to the number of units required by Goods Division. In this case, the minimum transfer price is equivalent to the incremental costs required to produce 50,000 units.

Direct materials | $10 |

Direct labor | 2 |

Variable overhead | 3 |

Incremental cost to produce 50,000 units for Goods Division | $15 |

The fixed overhead and fixed selling and administrative expense are not included as these will not change whether Components Division will sell 50,000 units to Goods Division or not. The variable selling expense is also not included as it will not be incurred if the part is sold to Goods Division.

$15

Transfer price

- the price between the internal buyer and internal seller but is subject to their ceiling.
- In this case, cost based pricing is used since no market price and negotiated transfer price. It means, the only costs of the internal seller will be considered in
**minimum**price to be set. - On the side of the internal seller, the price to be offered shall atleast cover the variable cost to be incurred on producing the goods to be sold to internal buyer. However, if there's no excess capacity, the price should also cover the opportunity cost of selling the goods to internal buyer than external (e.g. lost contribution margin)
- To summarize:

Minimum price of internal seller to internal buyer:

No excess capacity

= Variable cost of production + Opportunity cost of selling to internal buyer

With excess capacity

= Variable cost of production

- On the point of view of internal buyer, a maximum price is set as these goods can be purchased outside.
**The maximum price that the internal buyer can accept shall be the selling price if purchased from external seller.**This is because, any price in excess of the external price is a LOSS to the internal buyer. (E.g. $30 is set by internal seller, the internal buyer would rather purchase from external seller as it can save $2 ($30-$28). **Hence, in this case, the management of internal buyer (Good division) shall only accept transfer prices up to $28 (maximum).**

Note that data of internal seller aren't considered as the question is on the point of view of the internal buyer.

$28

Hi there!

Just an overview of the topic, transfer pricing is an accounting practice wherein the company calculates the price that one department can charge to the other department for the transfer of goods or services to them. Please take note that the goal here is how the company can benefit as a WHOLE.

Generally, there are two transfer prices that needs to be considered. These are:

1. **Maximum Transfer Price** - think of the computation of this price in this way "HOW MUCH WILL GOODS DIVISION BE WILLING TO PAY FOR THE UNITS TO COMPONENTS DIVISION? The answer is simply up to the **SELLING PRICE OF THEIR CURRENT OUTSIDE SUPPLIER**, of course, if Components Division will sell the price higher than the Good's Division current supplier, they will rather buy it to the supplier instead. Which in this problem was at $ 28 per unit.

2. **Minimum Transfer Price **- to get this, the question is "HOW MUCH IS COMPONENT'S DIVISION WILLING TO SELL THE PARTS TO GOODS DIVISION? The answer in this, IT DEPENDS. It depends whether Components Division has **EXCESS CAPACITY** or **WITH NO CAPACITY**.

How to know if the division has excess capacity?

Using the problem, it states that Component has a capacity to produce 200,000 units per year and about 150,000 units can be sold to outside customers, therefore the division has excess capacity of 50,000 units that can be sold to Goods Division. **Take note if the division has the excess capacity the minimum transfer price is equivalent to the variable cost per unit which was $ 15 per unit in this problem.**

Variable Cost per unit = Direct Materials + Direct Labor + Variable Overhead

= $10 + $2 + $3

** = $15**

Please take note that Variable Selling expense is also a variable cost but it is stated in the problem that this cost will not be incurred when they sold the units internally, so we have to ignore this in our computation.

**Take note that if the division has no excess capacity the minimum Transfer Price should be the sum of variable cost per unit and the opportunity cost of the selling division which is the contribution margin. To compute for the contribution margin, deduct the variable cost to the selling price of the goods. **In this problem, the Contribution Margin will be $29 - $16 = $13 per unit. Take note for this one, we added the variable selling price of $1 per unit in Variable Cost since this pertains to selling to outside customers. But since Components Division has excess capacity, we should not consider this opportunity cost in our computation because regular sales will not be affected even if the division will sell the 50,000 units to Goods Division.

Going back to the question, Goods Division offered Components Division to buy the parts at $18 per unit. To answer if we should accept or not, let's compare this price to the computed minimum transfer price with excess capacity which is $15 per unit.

Accept or Reject

Income - Incremental Costs = Profit/ Loss

$18 - $15 = $3 per unit profit or $150,000 ($3 * 50,000 units)

Decision: Accept!

**To summarize:**

**Maximum TP = selling price per unit to outsider**

**Minimum TP - if with excess capacity = Variable cost per unit**

** - if without excess capacity = Variable cost per unit + Contribution Margin**

**Then, compare the minimum transfer price computed to the selling price that the division is willing to pay. If positive, accept an if will result to loss, then reject.**

Study well.

The answer is YES. The transfer should take place because this will result to a profit for Components Division and a deduction of expense for Goods Division, both of which will be a benefit for the whole company.

If I am the manager of Component's Division, I will accept the offer of Goods Division to buy the parts at $18 per unit. Why? First of all, my department can produce 200,000 units per year and with these I'm just expecting 150,000 units to be sold to outsiders, therefore I still have a remaining 50,000 units - whether I sold this to Goods Division my regular outside sales will not be affected because I have sufficient units to cover these. In addition, if I'm gonna sell these units to Goods Division even at $18 per unit which is lower than my regular price, I will still earn a profit since the incremental cost that I will incur is only $15 per unit equivalent to variable cost per unit. Needless to say, the internal transfer will result to an additional profit for my division by $3 per unit or a total of $150,000 (50,000units* $3).

__Step 1:__ First, prepare the income statement

- Sales: In the problem, it is stated that the division is capable of producing 200,000 units of the part per year.
- First, it was mentioned that we are to assume that 50,000 are transferred to Goods Division @ $21 each.
- Therefore, the
__sales to goods division__= 50,000 x 21 =__$1,050,000__

- Therefore, the
- Second, since the division can only produce 200,000 units and it already sold 50,000 units to the goods division, then it can only sell 150,000 units to external customers. Note that the division is selling at a higher price of $29 to external customers.
- Therefore the
__sales to external customers__= 150,000 x 29 =__$4,350,000__

- Therefore the

- First, it was mentioned that we are to assume that 50,000 are transferred to Goods Division @ $21 each.
- Variable Costs
__Cost of goods sold__:- The variable cost of goods sold include:
- Direct materials = 10
- Direct labor = 2
- Variable overhead = 3

- Therefore, the total variable cost of goods sold per unit = 15. We have to multiply this $15/unit to the total number of units sold (200,000). Thus, the total variable cost of goods sold = 15 x 200,000=
__$3,000,000__

- The variable cost of goods sold include:
__Selling expenses__- Note that the division would only incur selling expenses for sales to external customers.
- Therefore variable selling expenses = 150,000 (units sold to external customers) x $1 =
__$150,000__

- Contribution margin = Sales - Variable Costs
- Contribution Margin = (4,350,000 + 1,050,000) - (3,000,000 + 150,000) = 2,250,000

- Fixed Cost
- Fixed Selling and administrative is given at
__$1,000,000__ - Fixed Overhead is computed by multiplying $5 to the total practical volume of 200,000 =
__$1,000,000__

- Fixed Selling and administrative is given at
- Therefore, operating income is at $750,000

__Step 2:__ Now that we have our operating income, we can now compute for ROI.

- ROI = Operating Income/Average Operating Assets
- The average operating assets of the Components Division, as provided in the problem, total $10 million

- Therefore, ROI = $ 750,000 / $10,000,000
__ROI = 0.075__

ROI = 0.075

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