12.27 Materials and manufacturing labour variances
Consider the following data collected for Tents‘n’Stuff Pty Ltd:
Direct
materials
$200 000
214 000
Cost incurred: actual inputs × actual prices
Actual inputs × standard prices
Standard inputs allowed for actual output ×
standard prices
Direct manufacturing
labour
$90 000
86 000
225 000
80 000
Required
Calculate the price, efficiency and flexible-budget variances for direct materials and direct
manufacturing labour.
Solution:
Materials and manufacturing labour variances
Direct materials
Actual Costs
Incurred
(Actual Input Qty
× Actual Price)
$200 000
$14 000 F
Price variance
Actual Input
Qty
× Budgeted
Price
$214 000
Flexible Budget (Budgeted
Input Qty Allowed for
Actual Output
× Budgeted Price)
$225 000
$11 000 F
Efficiency variance
$3000 F
Flexible-budget variance
Direct manufacturing labour:
$90 000
$86 000
$80 000
$4 000 U
$6 000 U
Price variance
Efficiency variance
$10 000 U
Flexible-budget variance
12.29 Price and efficiency variances, journal entries
Whangaratta Ltd manufactures ceramic lamps. It has set up the following standards per finished unit
for direct materials and direct manufacturing labour:
Direct materials: 10 kg at $4.50 per kg
Direct manufacturing labour: 0.5 hours at $30
per hour
$45.00
15.00
The number of finished units budgeted for January was 5 000; 4 550 units were actually produced.
Actual results in January were:
Direct materials: 45 055 kg used
Direct manufacturing labour: 2 250 hours
$70 875
Assume that there was no beginning inventory of either direct materials or finished units.
During the month, materials purchases amounted to 50 000 kg, at a total cost of $232 500. Price
variances are isolated upon purchase. Efficiency variances are isolated at the time of usage.
Required
1. Calculate the January price and efficiency variances of direct materials and direct manufacturing
labour.
2. Prepare journal entries to record the variances in requirement 1.
3. Comment on the January price and efficiency variances of Whangaratta Ltd.
4. Why might Wangaratta Ltd calculate direct materials price variances and direct materials
efficiency variances with reference to different points in time?
Solution:
Price and efficiency variances, journal entries
1. Direct materials and direct manufacturing labour are analysed in turn:
Actual Costs
Incurred
(Actual Input Qty
× Actual Price)
Direct
Materials
(100 000 × $4.65a)
$465 000
Actual Input Qty× Budgeted Price
Purchases
Usage
(100 000 × $4.50) (98 055 × $4.50)
$450 000
$441 247.50
$15 000 U
Efficiency variance
Direct
Manuf.
Labour
(4 900 × $31.50b)
$154 350
b
2.
(5 000 × 10 × $4.50)
$225 000
$216 247.50 U
Price variance
(4 900 × $30)
$147 000
(0.5 × 5000× $30)
$75 000
$7 350 U
Price variance
a
Flexible Budget
(Budgeted Input
Qty Allowed for
Actual Output
× Budgeted Price)
$72 000 U
Efficiency variance
$232 500 ÷ 50 000 = $4.65
$154 350 ÷ 4 900 = $31.50
Direct Materials Control
Direct Materials Price Variance
Accounts Payable or Cash Control
Work-in-Process Control
Direct Materials Efficiency Variance
Direct Materials Control
Work-in-Process Control
Direct Manuf. Labour Price Variance
Direct Manuf. Labour Efficiency Variance
Wages Payable Control
450 000
15 000
225 000
216 247.50
75 000
7 350
72 000
465 000
441 247.50
154 350
3. All variances are unfavourable.
4. The purchasing point is where responsibility for price variances is most often found. The
production point is where responsibility for efficiency variances is most often found.
Whangaratta Ltd may calculate variances at different points in time to tie in with these different
responsibility areas. Furthermore, determining the price variance based on purchase quantity
identifies the variance more quickly so that it can be tracked to specific purchase decisions.
18.18 Capital budget methods, no income taxes
Yummy Candy Ltd is considering purchasing a second chocolate dipping machine in order to expand
their business. The information Yummy has accumulated regarding the new machine is:
Cost of the machine
Increased contribution margin
Life of the machine
Required rate of return
$80 000
$15 000
10 years
6%
Yummy estimates that they will be able to produce more candy and thus increase their contribution
margin each year. They also estimate that there will be a small disposal value of the machine but the
cost of removal will offset that value. Ignore income tax issues in your answers. Assume that all cash
flows occur at year-end except for initial investment amounts.
Required
1. Calculate the following for the new machine:
a. net present value
b. payback period
c. internal rate of return
d. accrual accounting rate of return based on the net initial investment (assume straightline depreciation).
2. What other factors should Yummy Candy consider in deciding whether to purchase the new
machine?
Solution: (22–25 min.)
Capital budget methods, no income taxes
1.
a. The table for the present value of annuities (Appendix B, Table 4) shows:
10 periods at 6% = 7.360
Net present value= A$15 000× (7.360) – A$80 000
= A$110 400 – $80 000
= A$30 400
If using Excel: NPV = A$30 401
b. Payback period= A$80 000 ÷ A$15 000 = 5.333 years
c. Internal rate of return:
A$80000 =Present value of annuity of A$15000 at R% for 10 years, or what factor (F) in the
table of present values of an annuity (Appendix B, Table 4) will satisfy the following equation.
A$80 000= A$15 000F
F
=
$80 000
$15 000
= 5.333
On the 10-year line in the table for the present value of annuities (Appendix B, Table 4), find
the column closest to 5.333; it is between a rate of return of 12% and 14%.
Interpolation is necessary:
12%
IRR rate
14%
Difference
Internal rate of return= 12% +[
5.650
––
5.216
0.434
0.317
](2%)
0.434
Present Value Factors
5.650
5.333
––
0.317
= 12% + (0.73) (2%) = 13.46%
If using Excel: IRR = 13.43%
d. Accrual accounting rate of return based on net initial investment:
Net initial investment
= A$80 000
Estimated useful life
= 10 years
Annual straight-line depreciation = A$80 000 ÷ 10 = A$8 000
Accrual accounting
rate of return
=
Increase in expected average annual operating income
Net initial investment
= ($15 000 – 8 000)/80 000 = 7 000/80 000 = 8.75%
Note how the accrual accounting rate of return, whichever way calculated, can produce
results that differ markedly from the internal rate of return.
2. Other than the NPV, rate of return and the payback period on the new computer system,
factors that Staples should consider are:
 Issues related to the financing the project, and the availability of capital to pay for the
system.
 The effect of the system on employee morale, particularly those displaced by the system.
Salesperson expertise and real-time help from experienced employees is crucial to the
success of a hardware store.
 The benefits of the new system for customers (faster checkout, fewer errors).
 The upheaval of installing a new computer system. Its useful life is estimated to be 3 years.
This means that Staples could face this upheaval again in 3 years. Also ensure that the
costs of training and other ‘hidden’ start-up costs are included in the estimated A$275000
cost of the new computer system.
18.22 Comparison of projects, no income taxes
Santolis is a rapidly growing eco-technology company that has a required rate of return of 14%. It
plans to build a new facility in Adelaide. The building will take two years to complete. The building
contractor offered Santolis a choice of three payment plans, as follows:



Plan I. Payment of $175 000 at the time of signing the contract and $4 700 000 upon
completion of the building. The end of the second year is the completion date.
Plan II. Payment of $1 625 000 at the time of signing the contract and $1 625 000 at the end
of each of the two succeeding years.
Plan III. Payment of $325 000 at the time of signing the contract and $1 500 000 at the end
of each of the three succeeding years.
Required
1. Using the net present value method, calculate the comparative cost of each of the three
payment plans being considered by Santolis.
2. Which payment plan should Santolis choose? Explain.
3. Discuss the financial factors, other than the cost of the plan, and the non-financial factors that
should be considered in selecting an appropriate payment plan.
Solution: (30 min.)
Comparison of projects, no income taxes
1.
Total
Present
Value
Present Value
Discount
Factors at 14%
Year
0
1
2
3
Plan I
A$ (175000)
1.000
(3 614 300)
0.769
A$(3 789 000)
With Excel this is A$3 616 497
A$(175 000)
A$(4 700 000)
Plan II
A$(1 625000)
1.000
(1425 125)
0.877
(1 249 625)
0.769
A$(4 299750)
With Excel A$4 300 823
A$(1 625 000)
A$(1 625 000)
A$(1 625 000)
Plan III
A$(325 000)
1.000
(1315 500)
0.877
(1153 500)
0.769
(1012 500)
0.675
A$(3 806 500)
With Excel A$3 807 448
A(325 000)
A$(1500 000)
A$(1 500 000)
A$(1 500 000)
Summary:
Plan I: (A$3 789 000)
Plan II: (A$4 299 750)
Plan III: (A$3 806 500)
2. Plan I has the lowest net present value cost. Plan I is the preferred one on
financial criteria.
3. Factors to consider, in addition to NPV, are:
a.
Financial factors including:
 Competing demands for cash.
 Availability of financing for project.
Note that Plan III is very close in terms of NPV but is a more even cash flow across three
years.
b.
Non-financial factors including:
 Risk of building contractor not remaining solvent. Plan II exposes Santolis most if the
contractor becomes bankrupt before completion because it requires more of the cash
to be paid earlier.
 Ability to have leverage over the contractor if quality problems arise or delays in

construction occur. Plans I and III give Santolis more negotiation strength by being
able to withhold sizable payment amounts if, say, quality problems arise in Year 1.
Investment alternatives available. If Santolis has capital constraints, the new building
project will have to compete with other projects for the limited capital available.
8.17
ABC, hierarchy of activities (CMA, adapted)
Vineyard Test Laboratories does heat testing (HT) and stress testing (ST) on materials, and operates
at capacity. Under its current costing system, Vineyard aggregates all operating costs of $1 190 000
into a single overhead cost pool. Vineyard calculates a rate per test-hour of $17 ($1 190 000 ÷ 70 000
total test-hours). HT uses 40 000 test-hours, and ST uses 30 000 test-hours. Gary Celeste, Vineyard’s
management accountant, believes that there is enough variation in test procedures and cost structures
to establish separate costing and billing rates for HT and ST. The market for test services is becoming
competitive. Without this information, any mis-costing and mis-pricing of its services could cause
Vineyard to lose business. Celeste divides Vineyard’s costs into four activity-cost categories:
a. Direct-labour costs, $146 000. These costs can be directly traced to HT, $100 000, and ST, $46
000.
b. Equipment-related costs (rent, maintenance, energy and so on), $350 000. These costs are
allocated to HT and ST on the basis of test-hours.
c. Set-up costs, $430 000. These costs are allocated to HT and ST on the basis of the number of
set-up hours required. HT requires 13 600 set-up hours, and ST requires 3 600 set-up hours.
d. Costs of designing tests, $264 000. These costs are allocated to HT and ST on the basis of the
time required for designing the tests. HT requires 3 000 hours, and ST requires 1 400 hours.
Required
1. Classify each activity cost as output-unit-level, batch-level, product-sustaining, or
organisation-sustaining. Explain each answer.
2. Calculate the cost per test-hour for HT and ST. Explain briefly the reasons why these
numbers differ from the $17 per test-hour that Vineyard calculated using its traditional
costing system.
3. Assess the accuracy of the product costs calculated using the current costing system and
the ABC system. How might Vineyard’s management use the hierarchy and ABC
information to better manage its business?
Solution: (25 min.)
ABC, hierarchy of activities
1. Output unit-level costs
a. Direct-labour costs, $146 000
b. Equipment-related costs (rent, maintenance, energy, and so on), $350 000
These costs are output unit-level costs because they are incurred on each unit of materials
tested, that is, for every hour of testing.
Batch-level costs
c. Set-up costs, $430 000
These costs are batch-level costs because they are incurred each time a batch of materials
is set up for either HT or ST, regardless of the number of hours for which the tests are
subsequently run.
Product-sustaining costs
d. Costs of designing tests, $264 000
These costs are product-sustaining costs because they are incurred to design the HT and ST
tests, regardless of the number of batches tested or the number of hours of test time.
2.
Heat Testing (HT)
Total
(1)
Direct labour costs (given)
Equipment-related costs
$5 per hour*  40 000 hours
$5 per hour*  30 000 hours
Set-up costs
$25 per set-up-hour†  13 600 set-uphours
$100
000
Per Hour
(2) = (1)  40
000 hrs
$2.50
200 000
340 000
Total costs
180 000
$820
000
Total
(3)
$ 46 000
Per Hour
(4) = (3)  30
000
Hrs
$1.53
5.00
150 000
5.00
90 000
3.00
84 000
2.80
$370 000
$12.33
8.50
$25 per set-up-hour†  3 600 set-uphours
Costs of designing tests
$60 per hour**  3 000 hours
$60 per hour**  1 400 hours
Stress Testing (ST)
4.50
$20.50
*$350 000  (40 000 + 30 000) hours = $5 per test-hour
†
$430 000  (13 600 + 3 600) set-up hours = $25 per set-up-hour
**$264 000  (3 000 + 1 400) hours = $60 per hour
At a cost per test-hour of $17, the traditional costing system under-costs heat testing ($20.50)
and over-costs stress testing ($12.33). The reason is that heat testing uses direct labour, setup, and design resources per hour more intensively than stress testing. Heat tests are more
complex, take longer to set up and are more difficult to design. The traditional costing system
assumes that testing costs per hour are the same for heat testing and stress testing.
3. The ABC system better captures the resources needed for heat testing and
stress testing because it identifies all the various activities undertaken when
performing the tests and recognises the levels of the cost hierarchy at which
costs vary. Hence, the ABC system generates more accurate product costs.
Vineyard’s management can use the information from the ABC system to make better pricing
and product mix decisions. For example, it might decide to increase the prices charged for the
more costly heat testing and consider reducing prices on the less costly stress testing. Vineyard
should watch if competitors are underbidding Vineyard in stress testing and causing it to lose
business. Vineyard can also use ABC information to reduce costs by eliminating processes and
activities that do not add value, identifying and evaluating new methods to do testing that
reduce the activities needed to do the tests, reducing the costs of doing various activities, and
planning and managing activities.
8.19
Traditional cost drivers and ABC cost drivers
Roadster Pty Ltd designs and produces automotive parts. In 2018, actual variable production overhead
is $280 000. Roadster’s costing system allocates variable production overhead to its three customers
based on machine-hours, and prices its contracts based on full costs. One of its customers has regularly
complained of being charged non-competitive prices, so Roadster’s management accountant, Matthew
Draper, realises that it is time to examine the consumption of overhead resources more closely. He
knows that there are three main departments that consume overhead resources: design, production
and engineering.
He interviews the department personnel and examines time records, which yield the following
information:
Required
1. Calculate the production overhead cost allocated to each customer in 2018 using machinehours as the cost driver.
2. Calculate the production overhead cost allocated to each customer in 2018 using departmentbased production overhead rates.
3. Comment on your answers in requirements 1 and 2 and identify which customer was most
likely to complain about being overcharged in the traditional system. If the new departmentbased rates are used to price contracts, identify the customer(s) that are most likely to be
unhappy. Suggest how Matthew should respond to these concerns.
4. Suggest to Roadster how it might further use the information available from its departmentby-department analysis of production overhead costs.
5. Roadster’s managers are wondering if they should further refine the department-by-department
costing system into an ABC system by identifying different activities within each department.
Outline the conditions under which it would or would not be worthwhile to further refine the
department costing system into an ABC system.
Solution: (20 min.)
Traditional cost drivers and ABC cost drivers
1.
Actual plant-wide variable
MOH rate based on machine
hours, $280 000  5 000
$56 per machine hour
Southern
Motors
Variable production overhead, allocated based on
machine hours
($56  300; $56  3 700; $56  1 000)
$16 800
Caesar
Motors
$207
200
Jupiter
Auto
$56
000
2.
Design
Production
Engineering
MOH in
2017
$ 35 000
25 000
220 000
Total
Driver Units
500
500
5 000
Rate
$70
$50
$44
per CAD-design hour
per engineering hour
per machine hour
Total
$280
000
Southern
Motors
Design-related overhead, allocated on CADdesign hours
(150  $70; 250  $70; 100  $70)
Production-related overhead, allocated on
engineering hours
(130  $50; 100  $50; 270  $50)
Engineering-related overhead, allocated on
machine hours
(300  $44; 3 700  $44; 1 000  $44)
Total
Caesar
Motors
Jupiter
Auto
$10 500
$ 17 500
$ 7 000
$ 35 000
6 500
5 000
13 500
25 000
13 200
$30 200
162 800
$185 300
44 000
$64 500
220 000
$280 000
Total
3.
Southern
Motors
Caesar
Motors
Jupiter
Auto
a. Department rates
(Requirement 2)
$30 200
$185 300
$64 500
b. Plant-wide rate
(Requirement 1)
$16 800
$207 200
$56 000
Ratio of (a) ÷ (b)
1.80
0.89
1.15
The production overhead allocated to Southern Motors increases by about 80% under the department
rates, the overhead allocated to Caesar decreases by about 11%, and the overhead allocated to Jupiter
increases by about 15%.
The three contracts differ sizably in the way they use the resources of the three departments.
The percentage of total driver units in each department used by the companies is:
Department
Design
Engineering
Production
Cost
Driver
CAD-design hours
Engineering hours
Machine hours
Southern
Motors
30%
26
6
Caesar
Motors
50%
20
74
Jupiter
Auto
20%
54
20
The Southern Motors contract uses only 6% of total machines hours in 2018, yet uses 30% of
CAD design-hours and 26% of engineering hours. The result is that the plant-wide rate, based
on machine hours, will greatly underestimate the cost of resources used on the Southern Motors
contract. This explains the 80% increase in indirect costs assigned to the Southern Motors
contract when department rates are used. The Jupiter Auto contract also uses far fewer
machine-hours than engineering-hours and is also under-costed.
In contrast, the Caesar Motors contract uses less of design (50%) and engineering
(20%) than of machine-hours (74%). Hence, the use of department rates will report lower
indirect costs for Caesar Motors than does a plant-wide rate.
Caesar Motors was probably complaining under the use of the traditional system
because its contract was being over-costed relative to its consumption of MOH resources.
Southern and Jupiter, on the other hand, were having their contracts under-costed and
underpriced by the traditional system. Assuming that Roadster is an efficient and competitive
supplier, if the new department-based rates are used to price contracts, Southern and Jupiter
will be unhappy. Roadster should explain to Southern and Jupiter how the calculation was done,
and point out Southern’s high use of design and engineering resources and Jupiter’s high use
of engineering resources relative to production machine hours. Roadster’s management should
discuss ways of reducing the consumption of those resources, if possible, and show willingness
to partner with them to do so. If the price rise is going to be steep, perhaps offer to phase in
the new prices.
4. Other than for pricing, Roadster can also use the information from the
department-based system to examine and streamline its own operations so that
there is Diamond value-added from all indirect resources. It might set targets
over time to reduce both the consumption of each indirect resource and the
unit costs of the resources. The department-based system gives RC more
opportunities for targeted cost management.
5. It would not be worthwhile to further refine the cost system into an ABC system
if (1) a single activity accounts for a sizeable proportion of the department’s
costs or (2) significant costs are incurred on different activities within a
department, but each activity has the same cost driver or (3) there wasn’t much
variation among contracts in the consumption of activities within a department.
If, for example, most activities within the design department were, in fact,
driven by CAD-design hours, then the more refined system would be more
costly and no more accurate than the department-based cost system. Even if
there was sufficient variation, considering the relative sizes of the three
department cost pools, it may only be cost-effective to further analyse the
engineering cost pool, which consumes about 79% ($220 000  $280 000) of
the production overhead.
The percentage of total driver units in each department used by the companies is:
Cost
Department
Driver
Design
CAD-design hours
Engineering
Engineering hours
Production
Machine hours
United
Motors
28%
19
3
Holden
Motors
51%
16
70
Nissan
Vehicle
21%
65
27
The United Motors contract uses only 3% of total machines hours in 2013, yet uses 28%
of CAD design-hours and 19% of engineering hours. The result is that the plant-wide rate,
based on machine hours, will greatly underestimate the cost of resources used on the
United Motors contract. This explains the 157% increase in indirect costs assigned to the
United Motors contract when department rates are used.
In contrast, the Holden Motors contract uses less of design (51%) and engineering (16%)
than of machine-hours (70%). Hence, the use of department rates will report lower
indirect costs for Holden Motors than does a plant-wide rate.
Holden Motors was probably complaining under the use of the simple system because its
contract was being overcosted relative to its consumption of MOH resources. United
Motors, on the other hand was having its contract undercosted and underpriced by the
simple system. Assuming that MP is an efficient and competitive supplier, if the new
department-based rates are used to price contracts, United Motors will be unhappy. MP
should explain to United Motors how the calculation was done, and point out United
Motors’s high use of design and engineering resources relative to production machine
hours. Discuss ways of reducing the consumption of those resources, if possible, and show
willingness to partner with them to do so. If the price rise is going to be steep, perhaps
offer to phase in the new prices.
4.
Other than for pricing, MP can also use the information from the department-based
system to examine and streamline its own operations so that there is maximum valueadded from all indirect resources. It might set targets over time to reduce both the
consumption of each indirect resource and the unit costs of the resources. The
department-based system gives MP more opportunities for targeted cost management.
5.
It would not be worthwhile to further refine the cost system into an ABC system if
there wasn’t much variation among contracts in the consumption of activities within a
department. If, for example, most activities within the design department were, in fact,
driven by CAD-design hours, then the more refined system would be more costly and no
more accurate than the department-based cost system. Even if there was sufficient
variation, considering the relative sizes of the 3 department cost pools, it may only be
cost-effective to further analyse the engineering cost pool, which consumes 78% (A$240
000  A$308 600) of the manufacturing overhead.
19.21 Effect of different transfer-pricing methods on division operating profit (CMA,
adapted)
Sampson Ltd has two divisions. The Forming Division produces moulds, which are then transferred to
the Finishing Division. The moulds are further processed by the Finishing Division and are sold to
customers at a price of $300 per unit. The Forming Division is currently required by Sampson Ltd to
transfer its total yearly output of 100 000 moulds to the Finishing Division at 120% of full manufacturing
cost. Unlimited numbers of moulds can be purchased and sold on the outside market at $180 per unit.
The following table gives the manufacturing cost per unit in the Forming and Finishing divisions for
2018:
Direct materials cost
Direct manufacturing labour cost
Manufacturing overhead cost
Total manufacturing cost per unit
Forming Division
$24
17
64a
$105
Finishing Division
$12
20
50b
$82
a
Manufacturing overhead costs in the Forming Division are 20% fixed and 80% variable.
Manufacturing overhead costs in the Finishing Division are 65% fixed and 35% variable.
b
Required
1. Calculate the operating profits for the Forming and Finishing divisions for the 100 000 moulds
transferred under the following transfer-pricing methods: (a) market price and (b) 120% of
full manufacturing cost.
2. Suppose that Sampson Ltd rewards each division manager with a bonus, calculated as 2% of
division operating profit (if positive). What is the amount of bonus that will be paid to each
division manager under the transfer-pricing methods in requirement 1? Which transfer-pricing
method will each division manager prefer to use?
3. What arguments would Scott Devon, manager of the Forming Division, make to support the
transfer-pricing method that he prefers?
Solution: (30 min.)
Effect of different transfer-pricing methods on division operating profit (CMA, adapted)
1.
Method A
Method B
Internal
Internal
Transfers at
Transfers at
Market Prices
120% of Full
Costs
Forming Division
Revenues:
$180, $126a × 100 000 units
Costs:
Division variable costs:
$92.20b × 100 000 units
Division fixed costs:
$12.80c × 100 000 units
Total division costs
Division operating profit
Finishing Division
Revenues:
$300 × 100 000 units
Costs:
Transferred-in costs:
$180 $126 × 100 000 units
Division variable costs:
$18 000 000
$12 600 000
9 220 000
9 220 000
1 280 000
10 500 000
$7 500 000
1 280 000
10 500 000
$2 100 000
$30 000 000
$30 000 000
18 000 000
12 600 000
$49.50d × 100 000 units
Division fixed costs:
$32.50e × 100 000 units
Total division costs
Division operating profit
4 950 000
4 950 000
3 250 000
26 200 000
$3 800 000
3 250 000
20 800 000
$9 200 000
a
$126 = Full manufacturing cost per unit in the Forming Division, $105 × 120%
Variable cost per unit in Forming Division = Direct materials + Direct manufacturing labour +
80% of manufacturing overhead = $24 + $17 + (80% × $64) = $92.20
c
Fixed cost per unit = 20% of manufacturing overhead = 20% × $64 = $12.80
d
Variable cost per unit in Finishing Division = Direct materials + Direct manufacturing labour
+ 35% of manufacturing overhead = $12 + $20 + (35% × $50) = $49.50
e
Fixed cost per unit in Finishing Division = 65% of manufacturing overhead = 65% × $50 =
$32.50
b
2. Bonus paid to division managers at 2% of division operating profit will be as follows:
Method A
Internal
Transfers at
Market
Prices
Method B
Internal Transfers
at 120% of Full
Costs
Forming Division manager’s bonus
(2%  $7 500 000; 2%  $2 100 000)
$150 000
$42 000
Finishing Division manager’s bonus
(2%  $3 800 000; 2%  $9 200 000)
$76 000
$184 000
The Forming Division manager will prefer Method A (transfer at market prices) because this
method gives $150 000 of bonus rather than $42 000 under Method B (transfers at 120% of
full costs). The Finishing Division manager will prefer Method B because this method gives $184
000 of bonus rather than $76 000 under Method A.
3. Scott Devon, the manager of the Forming Division, will appeal to the existence of a competitive
market to price transfers at market prices. Using market prices for transfers in these conditions
leads to goal congruence. Division managers acting in their own best interests would state that
they make decisions that are in the best interests of the company as a whole.
Devon will further argue that setting transfer prices based on cost will cause to pay no attention
to controlling costs since all costs incurred will be recovered from the Finishing Division at 120%
of full costs.