ACT B405F Week 12 Tutorial
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.
SOLUTION
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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?
(20 min.) General guideline, transfer pricing.
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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.
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Contribution margin per screen = $92 – $65 = $27
Using the general guideline,
Minimum transfer = Incremental cost per + Opportunity cost per
screen incurred up to
screen to the
price per screen
the point of transfer
selling division
= $65 + $27 = $92
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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.
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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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22-28 Effect of alternative transfer-pricing methods on division operating income. Cran
Health 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:
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Required:
1. Compute Cran Health’s operating income from harvesting 480,000 pounds of cranberries
during June 2017 and processing them into juice.
2. Cran Health rewards its division managers with a bonus equal to 6% of operating income.
Compute the bonus earned by each division manager in June 2017 for each of the following
transfer-pricing methods:
a. 225% of full cost
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b. Market price
3. Which transfer-pricing method will each division manager prefer? How might Cran Health
resolve any conflicts that may arise on the issue of transfer pricing?
SOLUTION
(30–35 min.) Effect of alternative transfer-pricing methods on division operating income.
1.
480,000
240,000
Revenues (240,000 gals.  $2.45 per gal.)
Costs:
Harvesting Division:
Variable costs (480,000 lbs.  $0.10 per lb.)
Fixed costs (480,000 lbs.  $0.30 per lb.)
Total Harvesting Division costs
Processing Division:
Variable costs (240,000 gals.  $0.18 per gal.)
Fixed costs (240,000 gals.  $0.35 per gal.)
Total Processing Division costs
Total costs
Operating income
$588,000
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2.
Pounds of cranberries harvested
Gallons of juice processed (500 gals per 1,000 lbs.)
Transfer price per pound (($0.10 + $0.30)  2.25; $0.68)
$ 48,000
144,000
192,000
$ 43,200
84,000
127,200
319,200
$268,800
225% of
Full Costs
$0.90
Market
Price
$0.68
$432,000
$326,400
48,000
144,000
192,000
$240,000
$ 14,400
48,000
144,000
192,000
$134,400
$8,064
$588,000
$588,000
432,000
43,200
84,000
559,200
326,400
43,200
84,000
453,600
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1. Harvesting Division
Revenues (480,000 lbs.  $0.90; $0.68)
Costs
Division variable costs (480,000 lbs.  $0.10 per lb.)
Division fixed costs (480,000 lbs.  $0.30 per lb.)
Total division costs
Division operating income
Harvesting Division manager's bonus (6% of operating income)
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2. Processing Division
Revenues (240,000 gals.  $2.45 per gal.)
Costs:
Transferred-in costs
Division variable costs (240,000 gals.  $0.18 per gal.)
Division fixed costs (240,000 gals.  $0.35 per gal.)
Total division costs
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Division operating income
Processing Division manager’s bonus (6% of operating income)
$ 28,800
$1,728
$134,400
$8,064
3.
Bonus paid to division managers at 6% of division operating income is computed above
and summarized below:
Internal Transfers
at 225% of Full Costs
Internal Transfers
at Market Prices
Harvesting Division manager’s bonus
(6% × $240,000; 6% × $134,400)
$14,400
$8,064
Processing Division manager’s bonus
(6% × $28,800; 6% × $134,400)
$1,728
$8,064
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The Harvesting Division manager will prefer to transfer at 225% 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.
Cran Health may resolve or reduce transfer pricing conflicts by:



Basing division managers’ bonuses on overall Cran Health profits in addition to
division operating income. This will motivate each manager to consider what is best
for Cran Health Products 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.
22-30 Multinational transfer pricing, global tax minimization. Express Grow Inc., based in
Ankeny, Iowa, sells high-end fertilizers. Express Grow has two divisions:
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■ North Italy mining division, which mines potash in northern Italy
■ U.S. processing division, which uses potash in manufacturing top-grade fertilizer
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The processing division’s yield is 50%: It takes 2 tons of raw potash to produce 1 ton of topgrade fertilizer. Although all of the mining division’s output of 8,000 tons of potash is sent for
processing in the United States, there is also an active market for potash in Italy. The foreign
exchange rate is 0.80 Euro = $1 U.S. The following information is known about the two
divisions:
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SOLUTION
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Required:
1. Compute the annual pretax operating income, in U.S. dollars, of each division under the
following transfer-pricing methods: (a) 150% of full cost and (b) market price.
2. Compute the after-tax operating income, in U.S. dollars, for each division under the transferpricing methods in requirement 1. (Income taxes are not included in the computation of costbased transfer price, and Express Grow does not pay U.S. income tax on income already
taxed in Italy.)
3. If the two division managers are compensated based on after-tax division operating income,
which transfer-pricing method will each prefer? Which transfer-pricing method will
maximize the total after-tax operating income of Express Grow?
4. In addition to tax minimization, what other factors might Express Grow consider in choosing
a transfer-pricing method?
(40 min.) Multinational transfer pricing, global tax minimization.
This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing
methods.
Summary data in U.S. dollars are:
÷ 0.8 = $ 70 per ton of raw potash
÷ 0.8 = $120 per ton of raw potash
÷ 0.8 = $320 per ton of raw potash
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North Italy Mining Division
Variable costs:
56 EURO
Fixed costs:
96 EURO
Market price:
256 EURO
U.S. Processing Division
Variable costs = $ 43 per ton of fertilizer
Fixed costs = $ 115 per ton of fertilizer
Market price = $1,190 per ton of fertilizer
1.
The transfer prices are:
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a.
150% of full costs
Mining Division to Processing Division
= 1.5 × ($70 + $120) = $285 per ton of raw potash
b.
Market price
Mining Division to Processing Division
= $320 per ton of raw potash
150% of
Full Cost
U.S. Processing Division
Division revenues, $1,190  4,000
Costs:
Transferred-in costs, $285, $320  8,000
Division variable cost, $43  4,000
Division fixed costs, $115  4,000
Total division costs
Division operating income
$2,560,000
560,000
960,000
1,520,000
$ 760,000
560,000
960,000
1,520,000
$1,040,000
$4,760,000
$4,760,000
2,280,000
172,000
460,000
2,912,000
$1,848,000
2,560,000
172,000
460,000
3,192,000
$1,568,000
150% of
Full Cost
Market
Price
North Italy Mining Division
Division operating income
Income tax at 30%
Division after-tax operating income
$760,000
228,000
$532,000
$1,040,000
312,000
$ 728,000
U.S. Processing Division
Division operating income
Income tax at 35%
Division after-tax operating income
$1,848,000
646,800
$1,201,200
$1,568,000
548,800
$1,019,200
150% of
Full Cost
Market
Price
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2.
$2,280,000
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North Italy Mining Division
Division revenues, $285, $320  8,000
Costs:
Division variable costs, $70  8,000
Division fixed costs, $120  8,000
Total division costs
Division operating income
Market
Price
3.
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North Italy Mining Division:
After-tax operating income
U.S. Processing Division:
After-tax operating income
Express Grow:
After-tax operating income
$ 532,000
$728,000
1,201,200
1,019,200
$1,733,200
$1,747,200
The North Italy Mining Division manager will prefer the higher transfer price of market price
and the U.S. Processing Division manager will prefer the lower transfer price equal to 150% of
full cost. Express Grow will maximize companywide net income by using the market price-based
transfer-pricing method. This method sources more of the total income in Italy, the country with
the lower income tax rate.
Factors that executives consider important in transfer pricing decisions include:
a. Performance evaluation
b. Management motivation
c. Pricing and product emphasis
d. External market recognition
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4.
Factors specifically related to multinational transfer pricing include:
a. Overall income of the company
b. Income or dividend repatriation restrictions
c. Competitive position of subsidiaries in their respective markets
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22-33 Transfer pricing, goal congruence, ethics. Cocoa Mill Chocolates manufactures
specialty chocolates and sells them to fine candy stores. The company operates two divisions,
cocoa and candy, as decentralized entities. The cocoa division purchases raw cacao beans and
processes them into cocoa powder. The candy division purchases cocoa powder and other
ingredients and uses them to produce gourmet chocolates. The cocoa division is free to sell
processed cocoa to outside buyers, and the candy division is free to purchase processed cocoa
from other sources. Currently, however, the cocoa division sells all of its output to the candy
division, and the candy division does not purchase materials from outside suppliers.
The processed cocoa is transferred from the cocoa division to the production division at
110% of full cost. The cocoa division purchases raw cacao beans for $4 per pound. The cocoa
division uses 1.25 pounds of raw cacao beans to produce one pound of processed cocoa. The
division’s other variable costs equal $1.25 per pound of output, and fixed costs at a monthly
production level of 20,000 pounds of cocoa are $0.75 per pound. During the most recent month,
20,000 pounds of processed cocoa were transferred between the two divisions. The cocoa
division’s capacity is 25,000 pounds of output.
With the increase in demand for dark chocolate, the candy production division expects to use
22,000 pounds of cocoa next month. Franklin Foods has offered to sell 2,000 pounds of cocoa
next month to the candy production division for $7.50 per pound.
Required:
1. Compute the transfer price per pound of processed cocoa. If each division is considered a profit
center, would the candy production manager choose to purchase 2,000 pounds next month
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from Franklin Foods?
2. What would be the cost to Cocoa Mill Chocolates if the 2,000 pounds had been produced by
the cocoa division and transferred to the candy division? Is the external purchase in the best
interest of Cocoa Mill Chocolates? What is the cause of this goal incongruence?
3. The candy division manager suggests that $7.50 is now the market price for processed cocoa,
and that this should be the new transfer price. Cocoa Mill’s corporate management tends to
agree. The cocoa division manager is suspicious. Franklin’s prices have always been much
higher than $7.50 per pound. Why the sudden price cut? After further investigation by the
cocoa division manager, it is revealed that the $7.50 per pound price was a one-time-only
offer made to the candy division due to excess inventory at Franklin. Future orders would be
priced at $8.00 per pound. Comment on the validity of the $7.50 per pound market price and
the ethics of the candy manager. Would changing the transfer price to $7.50 matter to Cocoa
Mill Chocolates?
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SOLUTION
(20 min.) Transfer pricing, goal congruence, ethics.
1.
The transfer price is 110% of the full cost per pound of processed cocoa:
1.10 [($4 × 1.25) + $1.25 + $0.75] = $7.70
Because $7.50 is below the transfer price of $7.70, the candy division manager would choose to
purchase the 2,000 pounds from Franklin.
2.
The cost to produce the additional 2,000 pounds of processed cocoa would include only
the variable costs of the cocoa because the cocoa division is not operating at capacity:
($4 × 1.25) + $1.25 = $6.25 per pound
The purchase is not in the best interest of Cocoa Mill because, if produced internally, the
additional 2,000 pounds would only cost the company $12,500 ($6.25 of variable cost per pound
of cocoa × 2,000 pounds). If purchased from Franklin, the cocoa would cost $15,000. The cause
of this goal incongruence is two-fold: setting a transfer price based on full cost treats fixed costs
as variable, and setting the price above full cost (in this case 110%) artificially inflates the cost to
the purchasing division.
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3.
$7.50 is not a valid market price because it could not be replicated on future orders. $8.00
is a more appropriate market price. The candy manager was not acting ethically in this situation
because he or she was withholding pertinent information from both upper management and the
cocoa division manager and was even promoting a position known to be false. If the transfer
price had been changed to $7.50, it would not have affected the company overall, but profit
incentive rewards would have been shifted away from the cocoa division manager and to the
candy manager.
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