Inclass Questions - Computations PDF

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INCLASS QUESTIONS, LECTURE EIGHT, CH 2222-19 Transfer-pricing methods, goal congruence. Calgary Lumber has a raw lumber division and a finished lumber division. The variable costs are as follows:■ Raw lumber division: $125 per 100 board-feet of raw lumber ■ Finished lumber division: $145 per 100 boa...

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INCLASS QUESTIONS, LECTURE EIGHT, CH 22 22-19 Transfer-pricing methods, goal congruence. Calgary Lumber has a raw lumber division and a finished lumber division. The variable costs are as follows: ■ Raw lumber division: $125 per 100 board-feet of raw lumber ■ Finished lumber division: $145 per 100 board-feet of finished lumber Required: Assume that there is no board-feet loss in processing raw lumber into finished lumber. Raw lumber can be sold at $175 per 100 board-feet. Finished lumber can be sold at $345 per 100 board-feet. 1. Should Calgary Lumber process raw lumber into its finished form? Show your calculations.

2. Assume that internal transfers are made at 130% of variable cost. Will each division maximize its division operating-income contribution by adopting the action that is in the best interest of Calgary Lumber as a whole? Explain.

3. 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 Calgary Lumber as a whole? Explain.

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22-26 General guideline, transfer pricing. The Slate Company manufactures and sells television sets. Its assembly division (AD) buys television screens from the screen division (SD) and assembles the TV sets. The SD, which is operating at capacity, incurs an incremental manufacturing cost of $65 per screen. The SD can sell all its output to the outside market at a price of $100 per screen, after incurring a variable marketing and distribution cost of $8 per screen. If the AD purchases screens from outside suppliers at a price of $100 per screen, it will incur a variable purchasing cost of $7 per screen. Slate’s division managers can act autonomously to maximize their own division’s operating income. Required: 1. What is the minimum transfer price at which the SD manager would be willing to sell screens to the AD? 2. What is the maximum transfer price at which the AD manager would be willing to purchase screens from the SD? 3. Now suppose that the SD can sell only 70% of its output capacity of 20,000 screens per month on the open market. Capacity cannot be reduced in the short run. The AD can assemble and sell more than 20,000 TV sets per month. a. What is the minimum transfer price at which the SD manager would be willing to sell screens to the AD? b. From the point of view of Slate’s management, how much of the SD output should be transferred to the AD?

c. If Slate mandates the SD and AD managers to “split the difference” on the minimum and maximum transfer prices they would be willing to negotiate over, what would be the resulting transfer price? Does this price achieve the outcome desired in requirement 3b?

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SOLUTION (30 min.) Transfer-pricing methods, goal congruence. 1.

Alternative 1: Sell as raw lumber for $175 per 100 board feet: Revenue Variable costs Contribution margin

$175 125 $ 50 per 100 board feet

Alternative 2: Sell as finished lumber for $345 per 100 board feet: Revenue Variable costs: Raw lumber Finished lumber Contribution margin

$345 $125 145

270 $ 75 per 100 board feet

Calgary Lumber will maximize its total contribution margin by processing raw lumber into finished lumber. An alternative approach is to examine the incremental revenues and incremental costs in the Finished Lumber Division: Incremental revenues, $345 – $175 Incremental costs Incremental gain 2.

$170 145 $ 25 per 100 board feet

Transfer price at 130% of variable costs: = $125 + ($125  0.30) = $162.50 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

$175 125 $ 50

$162.50 125.00 $ 37.50

$ 0 —

$345.00 162.50 145.00 $ 37.50

$

0

The Raw Lumber Division will maximize reported division operating income by selling raw lumber, which is not the action preferred by the company as a whole. The Finished Lumber

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Division will maximize division operating income by processing raw lumber further, which coincides with the action preferred by the company as a whole. 3.

Transfer price at market price = $175 per 100 board feet. Sell as Raw Lumber

Sell as Finished Lumber

$175 125 $ 50

$175 125 $ 50

$

$345 175 145 $ 25

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

0 — — $ 0

Since the Raw Lumber Division will be indifferent between selling the lumber in raw or finished form, it would be willing have the raw lumber processed further, which is the action preferred by the company as a whole. The Finished Lumber Division will maximize division operating income by processing raw lumber further 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 entire organization.

SOLUTION (20 min.) General guideline, transfer pricing. 1. The minimum transfer price that the SD would demand from the AD is the net price it could obtain from selling its screens on the outside market: $100 minus $8 marketing and distribution cost per screen, or $92 per screen. The SD is operating at capacity. The incremental cost of manufacturing each screen is $65. Therefore, the opportunity cost of selling a screen to the AD is the contribution margin the SD would forego by transferring the screen internally instead of selling it on the outside market. Contribution margin per screen = $92 – $65 = $27 Using the general guideline, Incremental cost per Opportunity cost per screen to the Minimum transfer screen incurred up to price per screen = the point of transfer + selling division

= $65 + $27 = $92 4

2. The maximum transfer price the AD manager would be willing to offer SD is its own total cost for purchasing from outside, $100 plus $7 per screen, or $107 per screen. 3a. If the SD has excess capacity (relative to what the outside market can absorb), the minimum transfer price using the general guideline is: for the first 6,000 units (or 30% of output), $65 per screen because opportunity cost is zero; for the remaining 14,000 units (or 70% of output), $92 per screen because opportunity cost is $27 per screen. 3b. From the point of view of Slate’s management, all of the SD’s output should be transferred to the AD. This would avoid the $7 per screen variable purchasing cost that is incurred by the AD when it purchases screens from the outside market and it would also save the $8 marketing and distribution cost the SD would incur to sell each screen to the outside market. 3c. If the managers of the AD and the SD could negotiate the transfer price, they would settle on a price between the minimum transfer price the SD will accept (from requirement 3a) and $107 per screen (the maximum transfer price the AD would be willing to pay). Any price in this range would be acceptable to both divisions for all of the SD’s output, and would also be optimal from Slate’s point of view. This would obviously apply to the “split the difference” price as well. When the SD has excess capacity, this rule would suggest a price of ($65 + $107)/2 = $86; for the other 70% of output that SD can sell externally, the rule indicates a price of ($92 + $107)/2 = $99.5. From a practical standpoint, note that the latter price also works when SD has excess capacity; as a result, the firm might prefer it as a stable benchmark price, keeping in mind of course that it credits SD with too high a profit even at times of unused capacity.

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