CH-19 Transfer Pricing – Cost Management: Strategies for Business Decisions : Book Guide

Chapter 19 Transfer Pricing ANSWERS TO REVIEW QUESTIONS 19.1 Transfer prices exist in centralized organizations to record the transfer of goods and services from one unit to another for the same reasons such organizations allocate costs (e.g., inventory valuation, cross-department monitoring). 19.2 Four methods by which transfer prices may be set are as follows: (a) A transfer price may be set equal to the additional outlay cost incurred because goods are transferred, plus the opportunity cost to the organization because of the transfer. (b) A transfer price may be based on the external market price. (c) A transfer price may be set on the basis of negotiations among the division managers. (d) A transfer price may be based on the cost of producing the goods or services to be transferred. 19.3 Market-based transfer pricing is considered optimal under many circumstances because it preserves divisional autonomy, yet encourages division managers to make economically optimal decisions for the company if divisions operate at capacity and there are no market transaction costs. 19.4 The key limitation is that market prices are often not readily available. The limitations of market-based transfer prices exist when the market price does not reflect the opportunity cost of the goods and services, for example when idle capacity is present. Also, temporary short-run fluctuations in market prices could lead to suboptimal long-run decisions. 19.5 The advantage of direct intervention is it promotes short-run profits by ensuring proper action. The disadvantages of such a practice are that top management will become too involved in pricing disputes, and division managers will lose flexibility and autonomy in their decision making. The company also loses the other advantages of decentralization. 19.6 Companies often use prices other than market prices for interdivisional transfers because (1) market prices may not be available, (2) market prices can lead to suboptimal behavior when the supplier division has idle capacity, or (3) the company is not otherwise indifferent between internal and external buying. 19.7 When actual costs are used as a basis for the transfer, any variances or inefficiencies in the selling division are passed along to the buying division. To promote responsibility in the selling division and to isolate variances within divisions, standard costs are usually used as a basis for transfer pricing in cost based systems. (Note: Standard cost transfer pricing is only appropriate if standard costs are up to date and reflect reasonable estimates of cost.) 19.8 The disadvantages of a negotiated transfer price system are that a great deal of management effort may be wasted on the negotiating process and that the negotiated price may be based more upon the managers’ ability to negotiate rather than economic factors. 19.9 The general transfer pricing rule is as follows: The minimal transfer price is equal to the transferring division’s outlay cost plus the opportunity cost incurred by the transferring division in making the transfer. 19.10 Multinational firms may be charged import duties, or tariffs, on goods transferred between divisions in different countries. These duties often are based on the reported value of the transferred goods. Such companies may have an incentive to set a low transfer price in order to minimize the duty charged on the transferred goods. ANSWERS TO CRITICAL ANALYSIS 19.11 The transfer price becomes revenue for the selling segment and a cost to the buying segment. An increase (decrease) in the transfer price increases (decreases) the selling segment’s operating profit and decreases (increases) the buying segment’s operating profit 19.12 Three goals of transfer pricing in a decentralized organization are (1) to coordinate the activities of various responsibility centers, (2) to motivate managers to perform in the company’s best interest and (3) to serve as a performance measure for responsibility centers. 19.13 A cost-based or negotiated cost-based transfer pricing method would be necessary. We recommend using differential standard costs to the supplier plus supplier’s opportunity costs of the internal transfer, if any. If a dual transfer pricing system is used, the supplier could be given a mark-up without charging it to the buyer. 19.14 The IRS claimed the U.S. subsidiary’s low profits and losses were caused by a transfer price set below an arms-length market-based price. Also, the IRS claimed the Japanese parent company should bear some of the costs of the U.S. subsidiary’s high inventory levels. 19.15 Because transfer prices can affect the assignment of income from one jurisdiction to another, there is a tendency to set a cross-jurisdictional transfer price in such a manner that income is shifted to the jurisdiction with a lower tax burden. Of course, management may need to be aware of differences in tax laws, currency controls and other factors when establishing a transfer price. Moreover, taxing authorities may challenge a transfer price that is deemed unreasonable. 19.16 Critics of negotiated transfer prices cite two potential drawbacks. First, negotiating a transfer price can lead to divisiveness and competition among division managers. Second, negotiating skill can take on greater importance than it should in evaluating division managers, whose divisional profits are affected by a negotiated transfer price. 19.17 Basing transfer prices on full absorption cost entails a serious risk of causing dysfunctional decision-making behavior. Full-cost-based transfer prices can lead the buying division to view costs that are non-unit-level costs for the company as a whole as unit-level costs to the buying division. This can cause faulty decision making. As an illustration, assume the following scenario. Whole Company has two divisions: Selling Division and Buying Division Selling Division transfers component XYZ to Buying Division, which assembles a final product, called instrument ABC. Selling Division has excess capacity. Selling Division’s costs in the production of component XYZ: Full cost = Variable cost + Allocated fixed overhead = $10 + ($600,000a / 20,000 unitsb) = $40 full absorption cost aBudgeted facility-level (fixed) overhead bPlanned production Buying Division’s costs in assembling instrument ABC: Cost of component XYZ = Transfer price (TP) from Selling Division Cost to complete product = $60 Total cost of instrument ABC = TP + $60 Buying Division has excess capacity and has received a special order for instrument ABC for $90 per unit. If the transfer price is set at the full absorption cost of $40, Buying Division’s total cost in assembling instrument ABC will be $100 (TP + $60 = $40 + $60). Buying Division’s manager will tend to reject the special offer, because the division will lose $10 per unit of instrument ABC sold in the special order (price – cost = $90 - $100). However, it would be in the best interests of the company as a whole, for the special offer to be accepted, because each unit of instrument ABC sold in the special order will make a positive contribution for the company as a whole in covering fixed costs and profit. Contribution to Whole Company = Price - Variable costs = $90 - ($10 + $60) = $20 Setting the transfer price equal to the full cost of $40 has turned a non-unit-level (fixed) cost in the Selling Division, and hence a non-unit-level cost for the company as a whole, into a unit-level (variable) cost from the viewpoint of the Buying Division manager. The manager would tend to reject the special offer, even though accepting it would benefit the company as a whole. Although the practice is common, transfer prices should not be based on full cost. The risk is too great that the cost behavior in the producing division will be obscured. This can all too easily result in dysfunctional decisions in the buying division. 19.18 For multinational companies, the income-tax implications of setting transfer prices can be so significant that these tax issues dominate all other aspects of the transfer-pricing problem. This situation results from the incentive for multinationals to use the transfer-pricing scheme to shift income from divisions in relatively high tax jurisdictions to divisions in relatively low tax jurisdictions. 19.19 Some observers believe that fairness is a criterion that should be considered in setting transfer prices. Students’ answers will vary widely as to what they believe constitutes a fair transfer price. Recent research suggests that despite the predictions of economic theory, managers may be less likely to base a transfer price on the outside market price if doing so would result in an unequal (“unfair”) distribution of firm profits across the divisions. SOLUTIONS TO EXERCISES 19.20 ( 20 min)Apply economic transfer pricing rule a. The minimum transfer price that Maintenance Division should obtain is $71 per hour. b. The maximum transfer price that Leasing Division should pay is $40 per hour. c. Answer (a) would be $29 per labor hour. Answer (b) would not be affected. 19.21 (20 min)Evaluate transfer pricing system a. Buyer Seller Company Transfer internally Pays $160.00 Receives $150 Pays $10 Pays $55 Pays 55 Pays $65 Sell / purchase outside Pays $157.50 Receives $150 Pays $7.50 Pays 55 Pays 55 Pays $62.50 Optimal to transfer externally. b. Buyer Seller Company Transfer internally Pays $160.00 Receives $150 Pays $10 Pays 55 Pays 55 Pays $65 Sell / purchase outside Pays $157.50 Receives and pays –0– Pays $157.50 Optimal to transfer internally. 19.22 (10 min) General transfer-pricing rule a. Transfer price = outlay cost + opportunity cost = $300* + $80† = $380 *Outlay cost = unit variable production cost †Opportunity cost = forgone contribution margin = $380 – $300 = $80 b. If the Fabrication Division has excess capacity, there is no opportunity cost associated with a transfer. Therefore: Transfer price = outlay cost + opportunity cost = $300 + 0 = $300 19.23 (25 min) Cost-based transfer-pricing a. The Assembly Division's manager is likely to reject the special order because the Assembly Division's incremental cost on the special order exceeds the division's incremental revenue: Incremental revenue per unit in special order $465 Incremental cost to Assembly Division per unit in special order: Transfer price $374 Additional variable cost 100 Total incremental cost 474 Loss per unit in special order $(9) b. The Assembly Division manager's likely decision to reject the special order is not in the best interests of Great Lakes Metals, Inc., since the company's incremental revenue on the special order exceeds the company's incremental cost: Incremental revenue per unit in special order $465 Incremental cost to company per unit in special order: Unit variable cost incurred in Fabrication Division $300 Unit variable cost incurred in Assembly Division 100 Total unit variable cost 400 Profit per unit in special order $ 65 19.23 (continued) c. Ideally, all managers in an organization should try to make decisions that are optimal for the whole company. However, it is often difficult for a division manager to know what actions will be optimal for the whole company. It is, therefore, difficult to fault a division manager who optimizes for his or her division, particularly when the incentive system is designed to encourage the division manager to maximize divisional profit. d. The transfer price could be set in accordance with the general rule, as follows: Transfer price = outlay cost + opportunity cost = $300 + 0* = $300 *Opportunity cost is zero, since the Fabrication Division has excess capacity. Now the Assembly Division manager will have an incentive to accept the special order since the Assembly Division's incremental revenue on the special order exceeds the incremental cost. The incremental revenue is still $465 per unit, but the incremental cost drops to $400 per unit ($300 transfer price + $100 variable cost incurred in the Assembly Division). 19.24 (15 min) Evaluate transfer pricing system If Division X buys from outsiders because the transfer price is greater than $145, this would cost the company $10,000. The difference between the price paid for the units from an outside supplier ($145) and the differential costs of producing in Division Y ($135) times the 1,000 units in the order = $10,000. 19.25 (45 min) International transfer pricing; internet search Students’ responses on this open-ended internet search exercise will vary widely, depending on their interests. Most students are quite surprised to learn how complex the tax implications are in international transfer-pricing scenarios. 19.26 (25 min) Evaluate transfer pricing system a. Different prices: (1) The opportunity cost might be considered the regular fare of 1.00 less the $.25 fee collected. (2) The full cost is $3.00 less the $.25 fee collected. (3) One might suggest that if the transit vehicles are not running at capacity, the opportunity cost is zero because the senior citizens are riding in seats that would otherwise be empty. b. Memphis Transit would prefer to be reimbursed at the full cost of $3.00 because it would receive more revenue. c. The state government would prefer a rate of zero so it would pay no money to the transit authority. 19.27 (15 min) Evaluate transfer pricing system With the possibility of increased production Division X has an opportunity cost of transferring to Division Y of $5.00 per square foot which is the appropriate transfer price. However, the opportunity cost of acquiring the warehouse space is $3.25 per square foot for Division Y. Therefore, it would be in the company’s best interest if Division Y rented the space from the outside company. [This assumes no additional costs such as moving expenses to Division Y in using outside facilities.] 19.28 (25 min) Evaluate pricing system Total Mr. Peterson’s Share Ms. Jefferies’ Share Decrease in profits at Outdoor Greenery ($1,500 )* ($900 ) ($600 ) Increase in profits at Lively Landscape Co. 1,500 * 300 900 Net change in profits $0 ($600 ) $300 *$1,500 = $15 per plant x 10% x 1,000 plants. 19.29 (30 min) Segment reporting Dollar amounts are in millions. a. Using an $8 million transfer price: Item Building Company Finance Company Outside revenue $68 $16 Transfer price 8 Total revenue 68 24 Less: Outside costs 52 14 Transfer 8 Total costs 60 14 Operating profit before tax $8 $10 b. Using a $4 million transfer price: Item Building Company Finance Company Outside revenue $68 $16 Transfer price 4 Total revenue 68 20 Less: Outside costs 52 14 Transfer 4 Total costs 56 14 Operating profit before tax $12 $6 19.30 (25 min) International transfer prices Analyze the tax liabilities in each jurisdiction using the alternative transfer prices. If the transfer price is $3 million, the tax liabilities are: Canada U.S. Revenues $3,000,000 $15,000,000 Third-party costs 2,000,000 6,000,000 Transferred goods costs 3,000,000 Total costs 2,000,000 9,000,000 Taxable income 1,000,000 6,000,000 Tax rate 60% 40% Tax liability $ 600,000 $2,400,000 Total tax liability $3,000,000 If the transfer price is $4 million, the tax liabilities are computed as follows: Canada U.S. Revenues $4,000,000 $15,000,000 Third-party costs 2,000,000 6,000,000 Transferred goods costs 4,000,000 Total costs 2,000,000 10,000,000 Taxable income 2,000,000 5,000,000 Tax rate 60% 40% Tax liability $1,200,000 $2,000,000 Total tax liability $3,200,000 The total tax liability is higher if profits are shifted to the country with the higher tax rate. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 19.31 (30 min) Segment reporting a. There are two transfer pricing issues: (1) The hotel is essentially transferring lodging services to the amusement park when the park issues discount coupons for stays at the hotel; and (2) The park is essentially transferring entertainment services to the hotel when the hotel issues free passes to the park. b. All dollar amounts are in thousands. Item Hotel Amusement Park Revenue: Outside revenue $22,400 $14,800 Transfer price 3,200 1,200 Total revenue $25,600 $16,000 Less: Outside costs $12,400 $10,000 Transfer 1,200 3,200 Total costs $13,600 $13,200 Operating profit before tax $12,000 $ 2,800 SOLUTIONS TO PROBLEMS 19.32(60 min) Analyze transfer pricing data a. If L sells to outside Contributions to L Outside sales 140,000 @ $16.00 $2,240,000 Leftover DLH [400,000 – (140,000 x 2)]  2.5 = 48,000. 48,000 units transferred @ $18.00 864,000 $3,104,000 Labor costs 400,000 hrs. @ $6.00 2,400,000 Contribution margin $ 704,000 b. Units transferred 120,000 @ $18.00 $2,160,000 Leftover DLH 400,000 – (120,000 x 2.5) = 100,000; (100,000 hrs  2) x $16.00 800,000 $2,960,000 Labor costs 2,400,000 Contribution margin $ 560,000 c. and d.* Division L Division N Company Sales by L to outside $2,240,000 $2,240,000 Sales by L to N 864,000 864,000 Sales by N to outside (120,000 x $45) $5,400,000 5,400,000 Total sales $8,504,000 Cost of labor in L 2,400,000 2,400,000 Cost of units transferred to N 864,000 864,000 Cost of units purchased from outside by N (120,000 – 48,000) x $18.50 1,332,000 1,332,000 Conversion cost in N $8 x 120,000 960,000 960,000 Contribution $ 704,000 $2,244,000 $2,948,000 $560,000. N’s contribution if 120,000 units were transferred to it would be $2,280,000 (= $5,400,000 – $2,160,000 – $960,000). Company contributions would be only $2,840,000. *This is based on the optimal company policy. If L sold 120,000 units to N, L’s total contribution would be EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 19.33 (30 min) Transfer pricing with imperfect markets; ROI; normal costing a. ROI for Division S: [90,000 x ($10 – $3)] – [$5 x 100,000] = $130,000 ROI= $130,000/$600,000 = 21.67% b. Note: Capacity is 100,000 units, so regular sales would be reduced to 80,000 units (100,000 units capacity – 20,000 units to Division T). (80,000 x $7) + [20,000 x ($6.20 – $3.00)] – $500,000 = $560,000 + $64,000 – $500,000 = $124,000 ROI = $124,000/$600,000 = 20.67% c. (80,000 x $7) + [20,000 x (TP – $3)] – $500,000 = $130,000 $560,000 + 20,000 TP – $60,000 – $500,000 = $130,000 20,000 TP = $130,000 TP = $130,000/20,000 units = $6.50, where TP = transfer price per unit. Proof: $560,000 + [20,000 x ($6.50 – $3.00)] – $500,000 = $560,000 + $70,000 – $500,000 = $130,000 ROI = $130,000/$600,000 = 21.67% EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 19.34 (40 min) Transfer pricing; performance evaluation issues a. The TD Division should not supply Jaydee with fitting 1726 for the $10.00 per unit price. TD is operating at capacity and would lose $5.00 ($15.00 – $10.00) for each fitting sold to Jaydee. The management performance of TD is measured by return on investment and dollar profits; selling to Jaydee at $10.00 per unit would adversely affect those performance measures. b. Gulf South Corporation would be $11.00 better off, in the short run, if TD supplied Jaydee the fitting for $10.00 and the brake unit was sold for $99.00. Assuming the $16.00 per unit for fixed overhead and administration represents an allocation of cost Jaydee incurs regardless of the brake unit order, Gulf would lose $5.00 in cash flow for each fitting sold to Jaydee but gain $16.00 plus mark-up from each brake unit sold by Jaydee. c. In the short run there is an advantage to Gulf of transferring the fitting at the $10.00 price and thus selling the brake unit for $99.00 plus mark-up. In order to make this happen, Gulf will have to overrule the decision of the TD Division management. This action would be counter to the purposes of decentralized decision making. If such action were necessary on a regular basis the decentralized decision making inherent in the divisionalized organization would be a sham. Then the organization structure is inappropriate for the situation. On the other hand if this is an occurrence of relative infrequency, the intervention of corporate management will not indicate inadequate organization structure. It may, however, create problems with division managements. In the case at hand, if Gulf’s management requires that the fitting be transferred at $10.00, the result will be to enhance Jaydee’s operating results at the expense of TD. This certainly is not in keeping with the concept that a manager’s performance should be measured on the results achieved by the decisions he controls. In this case, it appears that TD and Jaydee serve different markets and do not represent closely related operating units. TD operates at capacity, Jaydee does not; no mention is made of any other interdivisional business. Therefore, the Gulf controller should recommend that each division should be free to act in accordance with its best interests. The company is better served in the long run if TD is permitted to continue dealing with its regular customers at the market price. If Jaydee is having difficulties, the solution does not lie with temporary help at the expense of another division but with a more substantive course of action. Note that Jaydee can still make the sale if it changes its allocation of fixed overhead and administration to $11.00 per unit. In that case, it can pay TD (or a competitor) $15.00 for the part and still arrive at a total cost of $99.00. Because it is not operating at capacity, it should be willing to try this. 19.35 (40 min) Comprehensive transfer-pricing analysis a. (1) Transfer price = outlay cost + opportunity cost = $65 + $15 = $80 (2) Transfer price = standard variable cost + (10%)(standard variable cost) = $65 + (10%) ($65) = $71.50 Note that the Frame Division manager would refuse to transfer at this price. b. (1) Transfer price = outlay cost + opportunity cost = $65 + 0 = $65 (2) When there is no excess 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 $15 ($80 – $65). When there is excess capacity in the Frame Division, there is no opportunity cost associated with a transfer. (3) Fixed overhead per frame (125%)($20) = $25 Transfer price = variable cost + fixed overhead per frame + (10%)(variable cost + fixed overhead per frame) = $65 + $25 + [(10%)($65 + $25)] = $99 (4) Incremental revenue per window $155 Incremental cost per window, for Bright House Window Corporation: Direct material (Frame Division) $15 Direct labor (Frame Division) 20 Variable overhead (Frame Division) 30 Direct material (Glass Division) 30 Direct labor (Glass Division) 15 Variable overhead (Glass Division) 30 Total variable (incremental) cost 140 Incremental contribution per window in special order for Bright House Window Corporation $15 19.35 (continued) The special order should be accepted because the incremental revenue exceeds the incremental cost for Bright House Window Corporation as a whole. (5) Incremental revenue per window $ 155 Incremental cost per window, for the Glass Division: Transfer price for frame [from requirement b(3)] $99 Direct material (Glass Division) 30 Direct labor (Glass Division) 15 Variable overhead (Glass Division) 30 Total incremental cost 174 Incremental loss per window in special order for Glass Division $ (19) The Glass Division manager has an incentive to reject the special order because the Glass Division's reported net income would be reduced by $19 for every window in the order. c. The use of a transfer price based on the Frame Division's full cost has caused a cost that is a fixed cost for the entire company to be viewed as a variable cost in the Glass Division. This distortion of the firm's true cost behavior has resulted in an incentive for a dysfunctional decision by the Glass Division manager. 19.36 (40 min) International transfer prices (1) Malaysian basis for transfer price (all dollar amounts in millions): Item Shipping Company Dock Service Co. Revenue: Outside revenue $26 $4 Transfer price 3 Total revenue 26 7 Less: Outside costs 17 5 Transfer 3 Total costs 20 5 Operating profit before tax (Revenue-costs) $6 $2 Tax rate x.75 x .20 Income taxes $4.5 $.4 Total taxes $4.9 (2) Great Britain basis for transfer price (all dollar amounts in millions): Item Shipping Company Dock Service Co. Revenue: Outside revenue $26 $4 Transfer price 8 Total revenue $26 $12 Less: Outside costs $17 $ 5 Transfer 8 Total costs $25 $5 Operating profit before tax (Revenues-costs) $1 $7 Tax rate x .75 x .20 Income taxes $.75 $1.4 Total taxes $2.15 The difference in taxes is $2,750,000, which is $4,900,000 minus $2,150,000. 19.37 (25 min) Transfer prices and tax regulations The transfer price economically optimal for Interglobal Company is $60 per unit. As illustrated below this is due to the difference in tax rates between the U.S. and France. It would thus be advantageous to Interglobal Company to charge as high a transfer price as possible so as to generate income in the U.S. and avoid the higher-tax rate of 70% in France. Profit after tax at the transfer price of $25/unit Div.X, U.S. Div. Y, France Selling Price $115 Transfer price $25 Transfers from U.S. $25 Variable cost 25 Shipping costs 15 Profit $0 Processing costs 10 50 65 Tax @ 70% 45.5 Profit after tax $19.5 Total profit after tax for Interglobal Company = $19.50/unit Profit after tax at the transfer price of $60/unit Div. X, U.S. Div. Y, France Transfer price $60 Selling price $115 Variable cost 25 Transfers from U.S. $60 Profit 35 Shipping costs 15 Tax @ 40% 14 Processing costs 10 85 Profit after tax $21 30 Tax @ 70% 21 Profit after tax $9 Total profit after tax for Interglobal Company = $21 + $9 = $30/unit 19.38 (40 min) Evaluate transfer price system a. Raleigh division management’s attitude at the present time should be positive to each of these prices in decreasing order because Raleigh apparently has unused capacity. Raleigh division management performance is evaluated based on return on investment (ROI) and each of these prices exceed variable costs which will increase Raleigh’s ROI. At the time when all existing capacity is being used, Raleigh division management would want the inter-company transfer price to generate the same amount of profit as outside business in order to maximize division ROI. b. Negotiation between the two divisions is the best method to settle on a transfer price. ESSI is organized on a highly decentralized basis and each of the four conditions necessary for negotiated transfer prices exist. These conditions are: • An outside market exists that provides both parties with an alternative. • Both parties have access to market price information. • Both parties are free to buy and sell outside the corporation. • Top management supports the continuation of the decentralized management concept. c. The main point to be addressed in the letter from the consultant could be stated as follows: The management of ESSI should not become involved in this controversy. The company is organized on a highly decentralized basis which top management must believe will maximize long-term profits. Imposing corporate restrictions will adversely affect the current management evaluation system because division management would no longer have complete control of profits. In addition, the addition of corporate restrictions could have a negative impact on division management who are accustomed to an autonomous working environment. 19.39 (40 min) Segment reporting a. All dollar amounts are in millions. Airline Hotel Auto Rental Travel Services Outside revenue $245 $106 $89 $32 Frequent stayer coupons 26 Auto discounts (airline) 7 Auto discounts (hotel) 3 Crew lodging 13 Travel commissions: Airline 4 Hotel 2 Auto 1 Total revenues $271 $119 $99 $39 Outside costs $157 $71 $66 $30 Frequent stayer coupons 26 Auto discounts (airline) 7 Auto discounts (hotel) 3 Crew lodging 13 Travel commissions: Airline 4 Hotel 2 Auto 1 Total costs $181 $102 $67 $30 Operating profits $90 $17 $32 $9 b. Adjust the operating profits in part (a.) for the changed transfer prices. Airline Hotel Auto Rental Travel Services Operating profits (a) $90 $17 $32 $9 Frequent stayer (21 ) 21 Auto coupons 6 (6 ) Operating profits (b) $75 $38 $26 $9 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 19.39 (continued) c. Divide the operating profits in (a) and (b) by division assets: For (a): Travel services 13.85% = $9/$65 Auto rental 9.97 = $32/$321 Airline 9.42 = $90/$955 Hotel 4.42 = $17/$385 For (b): Travel services 13.85% = $9/$65 Hotel 9.87 = $38/$385 Auto rental 8.10 = $26/$321 Airline 7.85 = $75/$955 The hotel moves from last place in the rankings to second, while the airline and auto rentals each drop in ranking. The transfer pricing method chosen does have an effect on the ROI-based rankings. 19.40 (50 min) Evaluate profit impact of alternative transfer decisions All dollar amounts are in thousands. a. (1) Bottle Division profits: Revenue $10,000 Cost 7,200 Profit $2,800 (2) Polish Division profits: Revenue $63,900 Cost 58,400 ( $48,400 + $10,000) Profit $5,500 (3) The corporation profits: Revenue $63,900 Cost 55,600 ( $48,400 + $7,200) Profit…………………. $8,300 19.40 (continued) b. (1) Yes Bottle Division Volumes Cases 2,000 4,000 6,000 Revenue $4,000 $7,000 $10,000 Cost 3,200 5,200 7,200 Profit $ 800 $1,800 $2,800 (2) No Polish Division Volumes Cases 2,000 4,000 6,000 Revenue $25,000 $45,600 $63,900 Cost* 20,400 39,400 58,400 Profit $4,600 $6,200 $5,500 (3) Yes Corporation Volumes Cases 2,000 4,000 6,000 Revenue $25,000 $45,600 $63,900 Cost 19,600 37,600 55,600 Profit $5,400 $8,000 $8,300 The bottle division and the corporation are the most profitable at the 6,000,000 volume and the polish division is most profitable at the 4,000,000 volume. Based on a market-based transfer price, the divisions achieve maximum profit for themselves at different levels of sales based on the market price at the various levels relative to the division costs at these various levels. The corporation achieves maximum profit based on the selling price to outsiders relative to the total cost of making the product. ________________________ *Production costs plus market price for the bottles. 19.41 (90 min) International transfer pricing The following table summarizes the problem data (and serves as data input for the spreadsheet solution referenced below). The solutions to requirements (a), (b) and (c) appear in the following tables. Summary of case data: Sweden's income tax rate on Swedish operating income 50% U.S. income tax rate on U.S. division's operating income 35% U.S. import duty based on transfer price 10% Variable manufacturing cost of product A4 $ 32.00 USD per unit Full (absorption) manufacturing cost of product A4 $ 50.00 USD per unit Net selling price in the U.S. $ 75.00 USD per unit Comparable imported product sales price in U.S. $ 65.00 USD per unit Sales price in Sweden $ 60.00 USD per unit Units sold 1,000,000 units Solutions to requirements (a), (b) and (c): a. Full manufacturing cost transfer price Sweden U.S Total b. Total Tax & Import Duty Sales revenue $50,000,000 $75,000,000 $75,000,000 Cost of goods sold 50,000,000 50,000,000 50,000,000 Import duties - 5,000,000 5,000,000 5,000,000 Operating profit - 20,000,000 20,000,000 Tax - 7,000,000 7,000,000 7,000,000 Operating profit after tax $ - $13,000,000 $13,000,000 $12,000,000 a. Comparable price transfer price Sweden U.S Total b. Total Tax & Import Duty Sales revenue $ 65,000,000 $75,000,000 $75,000,000 Cost of goods sold 50,000,000 65,000,000 50,000,000 Import duties - 6,500,000 6,500,000 6,500,000 Operating profit 15,000,000 3,500,000 18,500,000 Tax 7,500,000 1,225,000 8,725,000 8,725,000 Operating profit after tax $ 7,500,000 $2,275,000 $9,775,000 $15,225,000 19.41 (continued) c. All sales in Sweden Sweden U.S Total b. Total Tax & Import Duty Sales revenue $60,000,000 $60,000,000 Cost of goods sold 50,000,000 50,000,000 Import duties - - - Operating profit 10,000,000 10,000,000 Tax 5,000,000 5,000,000 5,000,000 Operating profit after tax $5,000,000 $5,000,000 $5,000,000 c. Swedish price transfer price Sweden U.S Total b. Total Tax & Import Duty Sales revenue $60,000,000 $75,000,000 $75,000,000 Cost of goods sold 50,000,000 60,000,000 50,000,000 Import duties - 6,000,000 6,000,000 6,000,000 Operating profit 10,000,000 9,000,000 19,000,000 Tax 5,000,000 3,150,000 8,150,000 8,150,000 Operating profit after tax $5,000,000 $5,850,000 $10,850,000 $14,150,000 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE SOLUTIONS TO CASES 19.42 (60 min) Transfer pricing; incentive systems a. The Logistics Division should accept the bid from Forwarders Division. Custom Freight Systems is $72 (= $185 – $113) better off if the Logistics division uses the Forwarders division for this contract. See detail calculations below. Option II: Purchase externally (United Systems) Total company cost = ($185) b. If we assume it is optimal for the transfer to be made internally, then the question arises as to the appropriate transfer price. The economic transfer pricing rule for making transfers to maximize a company’s profits is to transfer at the differential outlay cost to the selling division plus the opportunity cost to the company of making the internal transfers. Differential Outlay Cost + Opportunity Cost of Transferring Internally = Transfer Price If the seller (the division supplying the goods or services) has idle capacity $175 + $0 = $175 If the seller has no idle capacity $175 + $35 = $210 ($210 selling price – $175 variable cost) 19.42 (continued) c. Espinosa has many alternatives to intervention or to forcing the manager of the Forwarders division to lower his price below $210. Each has advantages and disadvantages. • Espinosa must trade-off the benefits of intervention on this particular transaction against the impact of intervention on decentralization as a policy. Too much intervention by Espinosa will eliminate the benefits of decentralization. • Tell the Logistics and Forwarder divisions that the transfer price will be between differential cost ($113) and the lowest outside market price ($185) and allow them to negotiate the profit. • Espinosa could reorganize the company combining the divisions into one operating company. However, Custom Freight Systems would lose all of the benefits of decentralization. • Espinosa could simply do nothing and let the managers maintain their autonomy. This would not be in the best interests of Custom Freight Systems. However, it might be better to sub-optimize for this transaction and obtain more general benefits from decentralizing. d. The reward system at Custom Freight Systems creates an environment that encourages managers to act in the best interests of their division rather than for the corporation. Managers are rewarded on their return on assets and profits which discourages discounting to other divisions of Custom Freight Systems and ultimately costs the corporation more. e. The Logistics Division should accept the bid from the Forwarders Division. However, if we eliminate the Forwarders Division from the bidding process, the bid from World should be accepted. Even though World’s bid is $10 per hundred pounds higher than United’s, the overall cost to Custom Freight Systems is lower because other divisions of Customer Freight Systems are included in the bid. Detailed calculations follow. 19.42 (continued) 19.43 (60 min) General transfer-pricing rule a. Minimum transfer price acceptable to the Appliance Division (for the range 0 to 2,000 units transferred): First, compute the contribution margin for A instruments and B instruments as follows: Instrument Sales Price Unit Variable Cost Unit Contribution Margin Direct-Labor Hours per Unit Contribution Margin per Hour A $45 $15 $30 1 $30 B 94 24 70 2 35 An hour of direct labor will make a larger contribution to the Appliance Division if spent on a B instrument than if spent on an A instrument. Therefore, for every B instrument transferred, up to a maximum of 2,000 units, the Appliance Division should cut back on its production of A instruments rather than B instruments. In the two hours required to produce a B instrument for transfer, the Appliance Division could produce two A instruments. Thus, the opportunity cost of transferring each B instrument, up to a maximum of 2,000 units, is the forgone contribution margin on two A instruments. The general transfer pricing rule yields the following minimal transfer price acceptable to the Appliance Division: Transfer price (range 0 to 2,000 units) = outlay cost + opportunity cost =$24 + (2  $30) = $84 For any number of B instruments transferred in the range zero to 2,000 units, the Appliance Division would not accept a transfer price less than $84 per unit. b. Minimum transfer price acceptable to the Appliance Division (for the range 2,001 to 5,000 units transferred): Each B instrument requires 2 hours of direct labor, and a maximum of 3,000 B instruments can be sold on the outside market. This production would require 6,000 direct-labor hours. 19.43 (continued) If more than 2,000 B instruments are transferred, the Appliance Division will have to decrease its production of B instruments for outside sale. Thus, the opportunity cost of transferring each B instrument in the range from 2,001 to 5,000 units is the contribution margin forgone on the outside sale of a B instrument. Using the general transfer pricing rule again, we have the following: Transfer price (range 2,001 to 5,000 units) = outlay cost + opportunity cost = $24 + $70 = $94 For each B instrument transferred in the range from 2,001 to 5,000 units, the Appliance Division would not accept a transfer price less than $94 per unit. c. Maximum transfer price acceptable to the Industrial Division (for the range 0 to 2,000 units): First, compute the contribution margin for Y gauges and Z gauges as follows: Gauge Sales Price Unit Variable Cost Unit Contribution Margin Direct-Labor Hours per Unit Contribution Margin per Hour Y $ 92 $22 $ 70 1 $ 70 Z 257 27* 230* 2 115 *Does not include or account for cost of B instrument. Therefore, for every Z gauge produced, up to a maximum of 2,000 units, the Industrial Division would pay up to $230 for a B instrument, since any transfer price lower than $230 would leave the Industrial Division with a positive contribution margin on its Z gauge. In this range, the Industrial Division would not need to cut into its Y gauge production in order to produce a Z gauge. 19.43 (continued) d. Maximum transfer price acceptable to the Industrial Division (for the range 2,001 to 5,000 units): If more than 2,000 Z gauges are produced, the Industrial Division will have to decrease its production of Y gauges. Thus, the Industrial Division would pay up to $90 ($257$27$140) for each B instrument transferred in the range from 2,001 to 5,000 units. In this calculation, the $140 is the lost contribution margin on the two Y gauges that the Industrial Division must forgo if it produces a Z gauge (in the range above 2,000 Z gauges). e. How many units will be transferred if the Appliance Division sets the transfer pricing schedule as follows: From 0 to 2,000 B instruments $84 From 2,001 to 5,000 B instruments 94 The Industrial Division will purchase exactly 2,000 B instruments. The $84 price in the range 0 to 2,000 units falls below the Industrial Division’s maximum in that range of $230. However, the $94 price in the range 2,001 to 5,000 units exceeds the $90 maximum acceptable to the Industrial Division in that range. Solution Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533