Week 8 (Feb. 28 and Mar.

2)

Homework #8 Problems and Solutions:

22-21 (30 min.) Effect of alternative transfer-pricing methods on division operating income.

(CMA, adapted) Ajax Corporation has two divisions. The mining division makes toldine, which
is then transferred to the metals division. The toldine is further processed by the metals division
and is sold to customers at a price of $150 per unit. The mining division is currently required by
Ajax to transfer its total yearly output of 200,000 units of toldine to the metals division at 110%
of full manufacturing cost. Unlimited quantities of toldine can be purchased and sold on the outside
market at $90 per unit.
The following table gives the manufacturing cost per unit in the mining and metals divisions
for 2014:

a
Manufacturing overhead costs in the mining division are 25% fixed and 75% variable.
b
Manufacturing overhead costs in the metals division are 60% fixed and 40% variable.

Required:
1. Calculate the operating incomes for the mining and metals divisions for the 200,000 units of
toldine transferred under the following transfer-pricing methods: (a) market price and (b) 110%
of full manufacturing cost.
2. Suppose Ajax rewards each division manager with a bonus, calculated as 1% of division
operating income (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 Brian Jones, manager of the mining division, make to support the
transfer-pricing method that he prefers?
SOLUTION

Method A Method B
Internal Transfers Internal Transfers at
at Market Prices 110% of Full Costs
1. Mining Division
Revenues:
$90, $661 × 200,000 units $18,000,000 $13,200,000
Costs:
Division variable costs:
$522 × 200,000 units 10,400,000 10,400,000
Division fixed costs:
$83 × 200,000 units 1,600,000 1,600,000
Total division costs 12,000,000 12,000,000
Division operating income $ 6,000,000 $ 1,200,000
Metals Division
Revenues:
$150 × 200,000 units $30,000,000 $30,000,000
Costs:
Transferred-in costs:
$90, $66 × 200,000 units 18,000,000 13,200,000
Division variable costs:
$364 × 200,000 units 7,200,000 7,200,000
Division fixed costs:
$155 × 200,000 units 3,000,000 3,000,000
Total division costs 28,200,000 23,400,000
Division operating income $ 1,800,000 $ 6,600,000
1
$66 = Full manufacturing cost per unit in the Mining Division, $60 × 110%
2
Variable cost per unit in Mining Division = Direct materials + Direct manufacturing labor + 75% of manufacturing
overhead = $12 + $16 + (75% × $32) = $52
3
Fixed cost per unit = 25% of manufacturing overhead = 25% × $32 = $8
4
Variable cost per unit in Metals Division = Direct materials + Direct manufacturing labor + 40% of manufacturing
overhead = $6 + $20 + (40% × $25) = $36
5
Fixed cost per unit in Metals Division = 60% of manufacturing overhead = 60% × $25 = $15
2. Bonus paid to division managers at 1% of division operating income will be as follows:

Method A Method B
Internal Transfers Internal Transfers at
at Market Prices 110% of Full Costs
Mining Division manager’s bonus
(1% × $6,000,000; 1% × $1,200,000) $60,000 $ 12,000
Metals Division manager’s bonus
(1% × $1,800,000; 1% × $6,600,000) 18,000 66,000

The Mining Division manager will prefer Method A (transfer at market prices) because
this method gives him $60,000 of bonus rather than $12,000 under Method B (transfers at 110%
of full costs). The Metals Division manager will prefer Method B because this method provides
$66,000 of bonus rather than $18,000 under Method A.

3. Brian Jones, the manager of the Mining 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 make
decisions that are also in the best interests of the company as a whole.
Jones will further argue that setting transfer prices based on cost will cause him to pay no
attention to controlling costs because all costs incurred will be recovered from the Metals Division
at 110% of full costs.
22-22 (30 min.) Transfer pricing, general guideline, goal congruence.

(CMA, adapted). Quest Motors, Inc., operates as a decentralized multidivision company. The Vivo
division of Quest Motors purchases most of its airbags from the airbag division. The airbag
division’s incremental cost for manufacturing the airbags is $90 per unit. The airbag division is
currently working at 80% of capacity. The current market price of the airbags is $125 per unit.

Required:
1. Using the general guideline presented in the chapter, what is the minimum price at which the
airbag division would sell airbags to the Vivo division?
2. Suppose that Quest Motors requires that whenever divisions with unused capacity sell products
internally, they must do so at the incremental cost. Evaluate this transfer-pricing policy using
the criteria of goal congruence, evaluating division performance, motivating management
effort, and preserving division autonomy.
3. If the two divisions were to negotiate a transfer price, what is the range of possible transfer
prices? Evaluate this negotiated transfer-pricing policy using the criteria of goal congruence,
evaluating division performance, motivating management effort, and preserving division
autonomy.
4. Instead of allowing negotiation, suppose that Quest specifies a hybrid transfer price that “splits
the difference” between the minimum and maximum prices from the divisions’ standpoint.
What would be the resulting transfer price for airbags?

SOLUTION

1. Using the general guideline presented in the chapter, the minimum price at which the
Airbag Division would sell airbags to the Vivo Division is $90, the incremental costs. The Airbag
Division has idle capacity (it is currently working at 80% of capacity). Therefore, its opportunity
cost is zero—the Airbag Division does not forgo any external sales and, as a result, does not forgo
any contribution margin from internal transfers. Transferring airbags at incremental cost achieves
goal congruence.

2. Transferring products internally at incremental cost has the following properties:

a. Achieves goal congruence—Yes, as described in requirement 1 above.
b. Useful for evaluating division performance—No, because this transfer price does not
cover or exceed full costs. By transferring at incremental costs and not covering fixed
costs, the Airbag Division will show a loss. This loss, the result of the incremental cost-
based transfer price, is not a good measure of the economic performance of the subunit.
c. Motivating management effort—Yes, if based on budgeted costs (actual costs can then
be compared to budgeted costs). If, however, transfers are based on actual costs, Airbag
Division management has little incentive to control costs.
d. Preserves division autonomy—No. Because it is rule-based, the Airbag Division has
no say in the setting of the transfer price.
3. If the two divisions were to negotiate a transfer price, the range of possible transfer prices
will be between $90 and $125 per unit. The Airbag Division has excess capacity that it can use to
supply airbags to the Vivo Division. The Airbag Division will be willing to supply the airbags only
if the transfer price equals or exceeds $90, its incremental costs of manufacturing the airbags. The
Vivo Division will be willing to buy airbags from the Airbag Division only if the price does not
exceed $125 per airbag, the price at which the Vivo division can buy airbags in the market from
external suppliers. Within the price range of $90 and $125, each division will be willing to transact
with the other and maximize overall income of Quest Motors. The exact transfer price between
$90 and $125 will depend on the bargaining strengths of the two divisions. The negotiated transfer
price has the following properties.
a. Achieves goal congruence—Yes, as described above.
b. Useful for evaluating division performance—Yes, because the transfer price is the
result of direct negotiations between the two divisions. Of course, the transfer prices
will be affected by the bargaining strengths of the two divisions.
c. Motivating management effort—Yes, because once negotiated, the transfer price is
independent of actual costs of the Airbag Division. Airbag Division management has
every incentive to manage efficiently to improve profits.
d. Preserves subunit autonomy—Yes, because the transfer price is based on direct
negotiations between the two divisions and is not specified by headquarters on the basis
of some rule (such as Airbag Division’s incremental costs).

4. Because the range of possible transfer prices is between $90 and $125 per unit, a “split the
difference” hybrid solution would lead to a transfer price of ($90 + $125)/2 = $107.50.

22-25 (20 min.) Transfer-pricing dispute.

The Kelly-Elias Corporation, manufacturer of tractors and other heavy farm equipment, is
organized along decentralized product lines, with each manufacturing division operating as a
separate profit center. Each division manager has been delegated full authority on all decisions
involving the sale of that division’s output both to outsiders and to other divisions of Kelly-Elias.
Division C has in the past always purchased its requirement of a particular tractor-engine
component from division A. However, when informed that division A is increasing its selling price
to $135, division C’s manager decides to purchase the engine component from external suppliers.
Division C can purchase the component for $115 per unit in the open market. Division A insists
that, because of the recent installation of some highly specialized equipment and the resulting high
depreciation charges, it will not be able to earn an adequate return on its investment unless it raises
its price. Division A’s manager appeals to top management of Kelly-Elias for support in the dispute
with division C and supplies the following operating data:

Required:
1. Assume that there are no alternative uses for internal facilities of division A. Determine
whether the company as a whole will benefit if division C purchases the component from
external suppliers for $115 per unit. What should the transfer price for the component be set at
so that division managers acting in their own divisions’ best interests take actions that are also
in the best interest of the company as a whole?
2. Assume that internal facilities of division A would not otherwise be idle. By not producing the
1,900 units for division C, division A’s equipment and other facilities would be used for other
production operations that would result in annual cash-operating savings of $22,800. Should
division C purchase from external suppliers? Show your computations.
3. Assume that there are no alternative uses for division A’s internal facilities and that the price
from outsiders drops $15. Should division C purchase from external suppliers? What should
the transfer price for the component be set at so that division managers acting in their own
divisions’ best interests take actions that are also in the best interest of the company as a whole?
SOLUTION

This problem is similar to the Problem for Self-Study in the chapter.

1. Company as a whole will not benefit if Division C purchases from external suppliers:
Purchase costs paid to external suppliers, 1,900 units × $115 $218,500
Deduct: Savings in variable costs by reducing
Division A output, 1,900 units × $105 199,500
Net cost (benefit) to company as a whole as a result of
purchasing from external suppliers $ 19,000

Any transfer price between $105 and $115 per unit will achieve goal congruence. Division
managers acting in their own best interests will take actions that are in the best interests of the
company as a whole.

2. Company as a whole will benefit if Division C purchases from external suppliers:

Purchase costs paid to external suppliers, 1,900 units × $115 $218,500
Deduct: Savings in variable costs,
1,900 units × $105 $199,500
Savings due to A’s equipment and
facilities assigned to other operations 22,800 222,300
Net cost (benefit) to company as a whole as a result of
purchasing from external suppliers $ (3,800)

Division C should not purchase from external suppliers.

3. Company as a whole will benefit if Division C purchases from external suppliers:

Purchase costs paid to external suppliers, 1,900 units × $100 $190,000
Deduct: Savings in variable costs by reducing
Division A output, 1,900 units × $105 199,500
Net cost (benefit) to company as a whole as a result of
purchasing from external suppliers $ (9,500)

The three requirements are summarized below (per unit, for 1,900 units):
(1) (2) (3)
Purchase costs paid to external suppliers $115 $115 $100
Relevant costs if purchased from Division A:
Incremental (outlay) costs if purchased from Division A 105 105 105
Opportunity costs if purchased from Division A – 12 –
Total relevant costs if purchased from Division A 105 117 105
Operating income advantage (disadvantage) to
company as a result of purchasing from Division A $ 10 $ (2) $ (5)

Goal congruence would be achieved if the transfer price is set equal to the total relevant costs of
purchasing from Division A.
22-31 (40 min.) Multinational transfer pricing, global tax minimization.

Supergrow, Inc., based in Des Moines, Iowa, sells high-end fertilizers. Supergrow has two
divisions:

 North Italy mining division, which mines potash in northern Italy

 U.S. processing division, which uses potash in manufacturing top-grade fertilizer

The processing division’s yield is 50%: It takes 2 tons of raw potash to produce 1 ton of top-grade
fertilizer. Although all of the mining division’s output of 12,000 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:

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 transfer-
pricing methods in requirement 1. (Income taxes are not included in the computation of cost-
based transfer price, and Supergrow 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 Supergrow?
4. In addition to tax minimization, what other factors might Supergrow consider in choosing a
transfer-pricing method?
SOLUTION

This is a two-country two-division transfer-pricing problem with two alternative transfer-pricing

methods.

Summary data in U.S. dollars are:

North Italy Mining Division

Variable costs: 72 EURO ÷ 0.8 = $ 90 per ton of raw potash
Fixed costs: 112 EURO ÷ 0.8 = $140 per ton of raw potash
Market price: 296 EURO ÷ 0.8 = $370 per ton of raw potash

U.S. Processing Division

Variable costs = $ 48 per ton of fertilizer
Fixed costs = $ 120 per ton of fertilizer
Market price = $1,150 per ton of fertilizer

1. The transfer prices are:

a. 150% of full costs
Mining Division to Processing Division
= 1.5 × ($90 + $140) = $345 per ton of raw potash

b. Market price
Mining Division to Processing Division
= $370 per ton of raw potash

150% of Market
Full Cost Price
North Italy Mining Division
Division revenues, $345, $370 × 12,000 $4,140,000 $4,440,000
Costs
Division variable costs, $90 × 12,000 1,080,000 1,080,000
Division fixed costs, $140 × 12,000 1,680,000 1,680,000
Total division costs 2,760,000 2,760,000
Division operating income $1,380,000 $1,680,000

U.S. Processing Division

Division revenues, $1,150 × 6,000 $6,900,000 $6,900,000
Costs
Transferred-in costs, $345, $370 × 12,000 4,140,000 4,440,000
Division variable cost, $48 × 6,000 288,000 288,000
Division fixed costs, $120 × 6,000 720,000 720,000
Total division costs 5,148,000 5,448,000
Division operating income $1,752,000 $1,452,000
2. 150% of Market
Full Cost Price
North Italy Mining Division
Division operating income $1,380,000 $1,680,000
Income tax at 30% 414,000 504,000
Division after-tax operating income $ 966,000 $1,176,000

U.S. Processing Division

Division operating income $1,752,000 $1,452,000
Income tax at 35% 613,200 508,200
Division after-tax operating income $1,138,800 $ 943,800

3. 150% of Market
Full Cost Price
North Italy Mining Division:
After-tax operating income $ 966,000 $1,176,000
U.S. Processing Division:
After-tax operating income 1,138,800 943,800
Supergrow:
After-tax operating income $2,104,800 $2,119,800

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. Supergrow 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.

4. Factors that executives consider important in transfer pricing decisions include the
following:
a. Performance evaluation
b. Management motivation
c. Pricing and product emphasis
d. External market recognition

Factors specifically related to multinational transfer pricing include the following:

a. Overall income of the company
b. Income or dividend repatriation restrictions
c. Competitive position of subsidiaries in their respective markets

22-33 (30–40 min.) International transfer pricing, taxes, goal congruence.

Castor, a division of Gemini Corporation, is located in the United States. Its effective income tax
rate is 30%. Another division of Gemini, Pollux, is located in Canada, where the income tax rate
is 40%. Pollux manufactures, among other things, an intermediate product for Castor called IP-
2014. Pollux operates at capacity and makes 15,000 units of IP-2014 for Castor each period, at a
variable cost of $56 per unit. Assume that there are no outside customers for IP-2014. Because the
IP-2014 must be shipped from Canada to the United States, it costs Pollux an additional $8 per
unit to ship the IP-2014 to Castor. There are no direct fixed costs for IP-2014. Pollux also
manufactures other products.
A product similar to IP-2014 that Castor could use as a substitute is available in the United
States for $77 per unit.

Required:
1. What is the minimum and maximum transfer price that would be acceptable to Castor and
Pollux for IP-2014, and why?
2. What transfer price would minimize income taxes for Gemini Corporation as a whole? Would
Castor and Pollux want to be evaluated on operating income using this transfer price?
3. Suppose Gemini uses the transfer price from requirement 2 and each division is evaluated on
its own after-tax division operating income. Now suppose Pollux has an opportunity to sell
8,000 units of IP-2014 to an outside customer for $62 each. Pollux will not incur shipping costs
because the customer is nearby and offers to pay for shipping. Assume that if Pollux accepts
the special order, Castor will have to buy 8,000 units of the substitute product in the United
States at $77 per unit.
a. Will accepting the special order maximize after-tax operating income for Gemini
Corporation as a whole?
b. Will Castor want Pollux to accept this special order? Why or why not?
c. Will Pollux want to accept this special order? Explain.
d. Suppose Gemini Corporation wants to operate in a decentralized manner. What transfer
price should Gemini set for IP-2014 so that each division acting in its own best interest
takes actions with respect to the special order that are in the best interests of Gemini
Corporation as a whole?

SOLUTION

1. The minimum transfer price would be $64 to cover the variable production ($56 per unit)
and shipping ($8 per unit) costs because Pollux would want, at a minimum, zero contribution
margin. The opportunity cost is $0 because there are no external customers for IP-2014. The
maximum transfer price would be the $77 market price that Castor would have to pay to acquire a
product similar to IP-2014 from the external market in the United States.

2. To minimize income taxes, Gemini should use a transfer price of $64. Canada has a higher
tax rate so goods coming from Canada should have the lowest transfer price. Pollux would not like
a transfer price of $64 because it would report no operating income from the transfer. Castor would
like a transfer price of $64 because it is lower than the outside market price of $77.

3a. It is easiest to see the solution to this problem if we assume a selling price for the product
that Castor manufactures, for example, $120. (The actual selling price you choose is irrelevant.)
 Pollux’s after-tax income on each unit from accepting the special order is as follows:
Revenue per unit $62.00
Variable cost per unit 56.00
Contribution margin per unit 6.00
Income taxes (0.40 × $6) 2.40
Increase in division income per unit after tax $ 3.60

Castor’s after-tax income on each unit if Pollux accepts the special order and Castor buys
the substitute product for IP-2014 in the United States for $77 per unit is as follows:
Revenue per unit $120.00
Variable cost per unit 77.00
Contribution margin per unit 43.00
Income taxes (0.30 × $43) 12.90
Increase in division income per unit after tax $ 30.10

Gemini’s total net income on each unit from Pollux accepting the special order is
therefore $3.60 + $30.10 = $33.70.

If Pollux rejects the special order and instead transfers the units internally to Castor at
$64 per unit, Pollux’s after-tax income would be as follows:
Revenue per unit $64
Variable cost per unit 64
Contribution margin per unit 0
Income taxes 0
Increase in division income per unit after tax $ 0

Castor’s after-tax income on each unit is as follows:

Revenue per unit $120.00
Variable cost per unit 64.00
Contribution margin per unit 56.00
Income taxes (0.30 × $56) 16.80
Increase in division income per unit after tax $ 39.20

Gemini’s total net income on each unit as a result of Pollux rejecting the special order and
transferring units of IP-2014 to Castor at $64 per unit is therefore $39.20 per unit. As this is higher
than $33.70, accepting the special order does not maximize after-tax operating income. After-tax
operating income is maximized by rejecting the special order.

3b. Castor will not want Pollux to accept the special order. It is more costly to buy from the
external market than from Pollux.

3c. Pollux will want to accept the special order because Pollux’s income per unit after-tax
increases by $3.60 per unit by accepting the special order rather than transferring IP-2014 to Castor
at $64 per unit and earning $0 operating income.
3d. Gemini should set the transfer price at $70 per unit. This will result in each division taking
actions in its own best interest that are also in the best interest of Gemini as a whole acting as a
decentralized organization.
The opportunity cost of transferring IP-2014 internally is $6 ($62 ─ $56) per unit for the
first 8,000 units and $0 per unit thereafter.

Using the general guideline,

Minimum transfer = Incremental cost per + Opportunity cost per
price unit inccurred up to unit to the
the point of transfer selling subunit

So, minimum = $64 + $6 = $70 per unit for the first 8,000 units
transfer price
$64 + $0 = $64 per unit for the next 7,000 units

Gemini should use these minimum transfer prices because they are also (reasonably) tax-
efficient.
At a transfer price of $70 per unit for the first 8,000 units, Pollux is indifferent between
accepting the special order or transferring internally. Pollux earns $6 per unit if it accepts the
special order. It also earns $6 per unit if it transfers IP-2014 to Castor ($70 - $64 variable cost per
unit).
Castor will prefer to “buy” IP-2014 from Pollux because the transfer price of $70 is less
than the $77 price it would pay to buy a product similar to IP-2014 in the United States.

The increase in Gemini’s income will be as follows:

From Pollux:
Revenue per unit $70.00
Variable cost per unit 64.00
Contribution margin per unit 6.00
Income taxes (0.40 × $6) 2.40
Increase in division income per unit after tax $ 3.60

From Castor:
Revenue per unit $120.00
Transfer price per unit 70.00
Contribution margin per unit 50.00
Income taxes (0.30 × $50) 15.00
Increase in division income per unit after tax $ 35.00

Increase in Gemini’s income = $3.60 + $35.00 = $38.60

This net income is greater than the $33.70 net income that Gemini would earn if Pollux
accepted the special order. It is less than the $39.20 that Gemini would earn if Pollux had
transferred IP-2014 at $64 per unit. Of course, if the transfer price is set at $64 per unit, Pollux
would accept the special order, which would lead to a lower net income of $33.70. If Gemini wants
to get the benefits of decentralization, it must be willing to suffer the consequences of higher taxes
that Pollux would have to pay.
 Note that Gemini would not want to set the transfer price any higher than $70, the minimum
transfer price that would induce Pollux to transfer internally to Castor. Why? Because setting the
transfer price any higher would result in exactly the same action (transferring IP-2014 internally)
but at a higher cost because of the higher taxes that Pollux would have to pay in Canada. Consider
for example a transfer price of $75 per unit. The increase in Gemini’s income will be as follows:

From Pollux:
Revenue per unit $75.00
Variable cost per unit 64.00
Contribution margin per unit 11.00
Income taxes (0.4 × $11) 4.40
Increase in division income per unit after tax $ 6.60

From Castor:
Revenue per unit $120.00
Transfer price per unit 75.00
Contribution margin per unit 45.00
Income taxes (0.30 × $45) 13.50
Increase in division income per unit after tax $ 31.50

Increase in Gemini’s income is $6.60 + $31.50 = $38.10, which is less than the $38.60 Gemini
earns if the transfer price is set at $70 per unit. A transfer price of $70 is the most tax-efficient
transfer price consistent with Gemini operating as a decentralized organization. Note also that the
transfer price cannot be set above $77 per unit because then Castor would buy a product similar to
IP-2014 in the United States rather than from Pollux.

22-34 (20 min.) Transfer pricing, goal congruence, ethics.

Sustainable Industries manufactures cardboard containers (boxes) made from recycled paper
products. The company operates two divisions, paper recycling and box manufacturing, as
decentralized entities. The recycling division is free to sell recycled paper to outside buyers, and
the box manufacturing division is free to purchase recycled paper from other sources. Currently,
however, the recycling division sells all of its output to the manufacturing division, and the
manufacturing division does not purchase materials from outside suppliers.
The recycled paper is transferred from the recycling division to the manufacturing division at
110% of full cost. The recycling division purchases recyclable paper products for $0.075 per
pound. The recycling division uses 100 pounds of recyclable paper products to produce one roll
of recycled paper. The division’s other variable costs equal $6.35 per roll, and fixed costs at a
monthly production level of 10,000 rolls are $2.15 per roll. During the most recent month, 10,000
rolls of recycled paper were transferred between the two divisions. The recycling division’s
capacity is 15,000 rolls.
With the increase in demand for sustainably made products, the manufacturing division expects
to use 12,000 rolls of paper next month. Ecofree Corporation has offered to sell 2,000 rolls of
recycled paper next month to the manufacturing division for $17.00 per roll.

Required:
1. Compute the transfer price per roll of recycled paper. If each division is considered a profit
center, would the manufacturing manager choose to purchase 2,000 rolls next month from
Ecofree Corporation?
2. Is the purchase in the best interest of Sustainable Industries? Show your calculations. What is
the cause of this goal incongruence?
3. The manufacturing division manager suggests that $17.00 is now the market price for recycled
paper rolls and that this should be the new transfer price. Sustainable’s corporate management
tends to agree. The paper recycling manager is suspicious. Ecofree’s prices have always been
much higher than $17.00 per roll. Why the sudden price cut? After further investigation by the
recycling division manager, it is revealed that the $17.00 per roll price was a one-time-only
offer made to the manufacturing division due to excess inventory at Ecofree. Future orders
would be priced at $18.50 per roll. Comment on the validity of the $17.00 per roll market price
and the ethics of the manufacturing manager. Would changing the transfer price to $17.00
matter to Sustainable Industries?

SOLUTION

1. The transfer price is 110% of the full cost per unit:

1.10 [($0.075 × 100) + $6.35 + $2.15] = $17.60

Because $17.00 is below the transfer price of $17.60, the manufacturing division manager would
choose to purchase the 2,000 rolls from Ecofree.

2. The purchase is not in the best interest of Sustainable Industries because, if produced
internally, the additional 2,000 rolls would only cost the company $27,700 ($13.85 of variable cost
per unit × 2,000 rolls). Because there is available capacity, fixed costs would be unaffected. If
purchased from Ecofree, the paper would cost $34,000. 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.

3. $17.00 is not a valid market price because it could not be replicated on future orders. $18.50
is a more appropriate market price. The manufacturing manager was not acting ethically in this
situation because he or she was withholding pertinent information from both upper management
and the recycling division manager and was even promoting a position known to be false. If the
transfer price had been changed to $17.00, it would not have affected the company overall, but
profit incentive rewards would have been shifted away from the recycling division manager and
to the manufacturing manager.