WEEK 11 (UNIT 10) - TUTORIAL SOLUTIONS

REVIEW QUESTIONS

12.16 The supplying and buying units of a company may negotiate a transfer price that is acceptable to both
parties. The general transfer pricing rule may provide the minimum transfer price, which benefits the
company as a whole, and the transfer price may fall between this price and the market price.

12.18 It is more appropriate to use cost-based transfer prices than market-based transfer prices when no
competitive external market exists.

12.19 An organisation may choose to use variable costs over absorption costs if there is no external market, as
using absorption costs can result in overpriced transfers and dysfunctional decisions.

EXERCISE 12.29 (10 minutes) General transfer pricing rule: manufacturer

1 If the Assembly Division has spare capacity, there is no opportunity cost associated with a transfer.
Therefore:

outlay opportunity
Transfer price = +
cost cost

= $450 + 0 = $450

2 outlay opportunity
Transfer price = +
cost cost

= $450 + $120† = $570

† Opportunity cost = forgone contribution margin

= $570 – $450 = $120

3 If the Assembly Division has spare capacity and no outside market exists for the transferred component,
the transfer price should be based on the variable cost per unit, $450, plus a small profit margin to provide
an incentive for the Assembly Division to manufacture and transfer the component to the Electrical
Division.
EXERCISE 12.30 (25 minutes) Cost-based transfer pricing: manufacturer
1 The Electrical Division’s manager is likely to reject the special offer because the Electrical Division’s
incremental cost on the special order exceeds the division’s incremental revenue:

Incremental revenue per unit of the special order $697.50

Incremental cost per unit to the Electrical Division per unit for the special
order:

Transfer price $561.00

Additional variable cost 150.00

Total incremental cost 711.00

Loss per unit in special order for the Electrical Division $ (13.50)

2 The Electrical Division manager’s decision to reject the special order is not in the best interests of the company
as a whole, since the company’s incremental revenue on the special order exceeds the company’s incremental
cost.

Incremental revenue per unit in special order $697.50

Incremental cost to company per unit in special order:

Unit variable cost incurred in Assembly Division $450.00

Unit variable cost incurred in Electrical Division 150.00

Total unit variable cost 600.00

Profit per unit in special order for the company as a whole $ 97.50

3 The transfer price could be set in accordance with the general rule, as follows:

Transfer price = outlay cost + opportunity cost

= $450 + 0*

= $450
* Opportunity cost is zero, since the Assembly Division has spare capacity.

The Assembly Division will want to make a profit on the transfer, so that transfer price will be $450 plus a profit
margin. The Electrical Division manager will have an incentive to accept the special order since the Electrical
Division’s incremental revenue on the special order exceeds the incremental cost. Any transfer price that is
between $450 and $547.50 will allow the Electrical Division to make a profit.
PROBLEM 12.39 (40 minutes) Transfer pricing problem: manufacturer

1 (a) Transfer price = outlay cost + opportunity cost

= $195 + $45 = $240

(b) Transfer price = standard variable cost + (10%)(standard variable cost)

= $195 + (10%)($195) = $214.50

Note that the Frame division manager would be likely to refuse to transfer at this price.

2 (a) Transfer price = outlay cost + opportunity cost

= $195 + 0 = $195

(b) When there is no spare capacity, the opportunity cost is the forgone contribution margin on an
external sale when a frame is transferred to the Glass division. The contribution margin equals $45
(i.e. $240 – $195). When there is spare capacity in the Frame division, there is no opportunity cost
associated with a transfer. Students should not be formula bound here but understand the rationale:
when there is no spare capacity this manager can sell all output for $240. Hence, they would not be
willing to transfer at $214.50. When there is spare capacity anything over $195 will increase their
profit. This argument is reflected in the use of the opportunity cost.

(c) Fixed overhead per frame (125%)($60) = $75

Transfer price = variable cost + fixed overhead per frame

+ (10%)(variable cost + fixed overhead per frame)

= $195 + $75 + [(10%)($195 + $75)]

= $297

(d) Incremental revenue per window $465

Incremental cost per window

Direct material (Frame division) $45

Direct labour (Frame division) 60

Variable overhead (Frame division) 90

Direct material (Glass division) 90

Direct labour (Glass division) 45

Variable overhead (Glass division) 90

Total variable (incremental) cost 420

Incremental contribution per window in special order

for Clear Windows Company $45

From the perspective of the company as a whole, the special order should be accepted because the
incremental revenue exceeds the incremental cost.
 (e) Incremental revenue per window $465

Incremental cost per window, for the Glass division:

Transfer price for frame [from requirement 2(c)] $297

Direct material (Glass division) 90

Direct labour (Glass division) 45

Variable overhead (Glass division) 90

Total incremental cost 522

Incremental loss per window in special order

for Glass division $ (57)

The Glass division manager has an incentive to reject the special order because the Glass division’s
reported net profit would be reduced by $57 for every window in the order.

3 The price to transfer 200 units from the Frame division to the Glass division is $285 per unit.
Minimum transfer price = incremental cost per unit + opportunity cost per unit
= [(200 × $195) + (150 × $120)]/200
= $57 000 / 200
= $285 per unit
This transfer price will not change the profits of the Frame division. If the units are transferred then the
Frame division may also add a profit margin to make the transfer worthwhile. Note that the Frame
division only has sufficient capacity to manufacture 100 of the total 200 units required by the Glass
division. The opportunity cost in this calculation relates to the forgone profit of $120 per unit for the 150
units that could not be manufactured and sold to external customers if the extra 100 units are
manufactured and transferred to the Glass division. The Frame division must consider any impact on
regular external customers if the Frame division cannot supply them with their usual product. This could
result in a decrease in the company’s reputation, and loss of future external sales as disappointed
customers seek out other suppliers.
The manager of the Frame division could transfer the 200 units at an average price of $285 per unit, or it
could transfer 100 units at anything above the variable cost of $195 per unit to utilise its spare capacity.
The manager of the Glass division will not find the price of $285 per unit for 200 units attractive, as it is
higher than the market price of $240 per unit. Thus, the manager would prefer to purchase 100 units at a
price less than the market price of $240 from the Frame division and the remaining 100 units at $240
from the external market. If the manager of the Glass division does not want to manage two suppliers or
if the Glass division insists on charging the market price, then the Glass division may end up purchasing
all of the 200 units from the outside supplier.
PROBLEM 12.41 (35 minutes) Multiple interdivisional transfers; accept or reject
outside contract: manufacturer

1 In order to maximise short-run contribution margin, the Brandon Division should accept the contract from
Westminster Company. This conclusion is supported by the following calculations:
(a) Brandon transfer to Gerard:
Transfer price (5000 units @ $2350 each) $11 750 000
Variable cost:
Purchase from Cromwell (5000 units @ $1000 each) $5 000 000
Processing by Brandon (5000 units @ $850 each) 4 250 000
Total variable cost 9 250 000
Contribution margin for Brandon Division $2 500 000
(b) Brandon accepts Westminster contract:
Selling price (4500 units @ $2075 each) $9 337 500
Variable cost:
Purchase from Cromwell (4500 units @ $850 each) $3 825 000
Processing by Brandon (4500 units @ $700 each) 3 150 000
Total variable cost 6 975 000
Contribution margin to Brandon Division $2 362 500
Conclusion:
Contribution margin from Westminster contract $2 362 500
Contribution margin from Gerard sale 2 500 000
Difference in favour of Westminster contract $137 500
2 Brandon Division’s decision to accept the contract from Westminster Company is in the best interest of
Reebutt Industries as the decision increases the overall contribution margin of the company. This
conclusion is supported by the following calculations.
Revenues and cost savings to Reebutt Industries:
Sales by Brandon to Westminster (4500 units @ $2075 each) $9 337 500
Sales by Cromwell to Fawkes (5000 units @ $700 each) 3 500 000
Cost savings (variable costs avoided by not accepting the Gerard order)
Cromwell’s savings (5000 units @ $550) 2 750 000
Brandon’s savings (5000 units @ $850) 4 250 000
Total revenue and cost savings $19 837 500

Expenditures incurred by Reebutt Industries:

Variable cost incurred for the Westminster order:
Brandon (4500 units @ $700 each) $3 150 000
Cromwell (4500 units @ $475 each) 2 137 500
Variable cost incurred for purchase:
Gerard from Fawkes (5000 units @ $2350 each) 11 750 000
Fawkes from Cromwell (5000 units @ $400 each) 2 000 000
Total expenditures incurred 19 037 500
Additional contribution margin to Reebutt Industries $800 000