This question is a practical question requiring answers to the questions at the end of the following information.
The Complete Mining and Manufacturing Company has several divisions and two of these are involved in the transfer of products. The Cleaning and Scraping Division produces raw Cruden and transfers it to the Processing Division where it is processed into an alloy. The Processing Division then sells it on the open market for $160 per unit. Currently the Complete Mining and Manufacturing Company requires all of the Cruden to be transferred from the Cleaning and Scraping Division to the Processing Division. Currently the Cleaning and Scraping Division produces 400,000 units per year and transfers it all to the Processing Division at total actual manufacturing cost plus 10%.
The Cruden can be purchased and sold on the open market for $95 and all that is sent to market can be sold on the market at this price. If the Cleaning and Scraping Division sells the Cruden on the open market it will incur a variable selling cost of $5 per unit .
The following details show the unit costs for the Cleaning and Scraping and Processing Divisions
Cleaning and Scraping Division Processing Division
Transfer price from Cleaning and Scraping $77
Direct material 18 5
Direct labour 12 10
Manufacturing overhead 40 25
Total cost per unit 70 117
Manufacturing overhead in Cleaning and Scraping is 25% fixed,75% variable
Manufacturing overhead in Processing is 60% fixed,40% variable
Required:
(a) Explain why transfer prices based on total actual costs are not appropriate as the basis for divisional performance measurement
(b)Using the market price as the transfer price, calculate the contribution margin for both divisions.
(c) If the Complete Mining and Manufacturing Company were to institute the use of negotiated transfer prices and allow divisions to buy and sell on the open market determine the price range for Cruden that would be acceptable to both divisions.
(d)Use the general transfer pricing rule to compute the lowest transfer price that would be acceptable to the Cleaning and Scraping Division? Will this transfer price be the one that the manager of the Cleaning and Scraping Division prefers? Provide an explanation for your answer to this question.
There are three pitfalls of using transfer price based on the total cost of production:
Generally, performance of divisions is measured with the contribution margin of the particular division. Generally, by fixing transfer price based on the total cost of production does not account for any value based pricing of product in the market. In our case as transfer pricing is based on the cost plus pricing and way lower than that of prevailing market price of Cruden that is $95, so by doing so company artificially lowed the performance of cleaning and scraping division and on the other end performance of processing unit is exaggerated due to the same. So the best way to determine the performance of each unit is when transfer pricing is taken as market price of the goods. In this case as mentioned the cleaning and scraping division is better off by selling the product in the market rather than selling to the different unit of same company. This is only possible when there is an efficient market of the goods.
The other pitfall of using full cost as transfer pricing is issue in analysis of cost behaviour. The full cost consists of variable cost and fixed cost for a particular company. So fixed cost portion of the selling unit is now converted into the variable cost for the buying unit of company. This lead to the wrong decision when analysing the cost of final product for the company.
Generally, full actual costs include certain degree of inefficiencies. So if the company is using it as a transfer pricing then often they fail to provide an incentive to the management to control such inefficiencies of the systems. At the same time fixed portion of cost is allocated based on the projected annual production figure and that is just an estimate of actual production. So this will also lead to certain calculation error of getting true transfer price of the product among different units.
Contribution margin corresponds to the marginal profit resulted from selling one unit of product. This is calculated as product’s price minus variable costs of the manufacturing of the product. The sum total of all the contribution margin represents the profit generated by the company after paying all the fix expenses. Form the given data:
Transfer price of Cruden = $95 per unit
Cleaning and scraping division processing division
Price of the final product sold 95 160
Variable Cost of goods sold* 60 120
(*if fix component of manufacturing cost is not taken in consideration)
Contribution margin 35/95 = 36.8% 40/160 = 25.0%
so from the calculation we see that contribution margin of each unit will depend on the transfer price of the product. In our case as we have taken market price as transfer price so contribution margin of the cleaning and scraping unit is higher than that of the processing unit division. The reason of this is that transfer price is the variable price of the processing unit and the more it is less will be the contribution margin.
When both buying and selling parties involved in the negotiation of transfer pricing then there are different objectives of each parties. The selling parties will not accept any price lower than the lowest transfer price and buying party will not accept any price any price higher than the maximum transfer price. In our case the lowest transfer price is $90 in case of no spare capacity of production and highest transfer price will be equal to the market price of Cruden that is $95.
So If Cruden is allowed to trade with open market, then negotiated price will be in the range of $90 – $95 per unit.
As mentioned that variable cost of selling Cruden in the market for cleaning and scraping division is $5 per unit. So maximum profit per unit this division can earn is $20 by selling in the open market. However, if they sell this product processing division then they can save this amount. On the other end if processing unit wants to buy Cruden from market then they need to pay at least $95 per unit. So they may consider buying Cruden at $95 form cleaning and scraping unit. So negotiated price range is $90-$95 per unit.
When we look at the lowest transfer price then we look from the selling division point of view of pricing. In this case there are two scenarios:
When division has spare capacity of production
When division do not have any spare production capacity
The lowest transfer price that selling division happy to sell is:
marginal cost + opportunity cost.
Opportunity cost is value of best forgone alternatives. So in case of spare capacity opportunity cost is zero and lowest price would be equal to marginal cost of production of product. However, in case of no spare capacity, opportunity cost defined as:
Get the market price of product
Calculate any additional cost savings if sold internally
deduct (ii) from (i) for lowest transfer price
In our case the product has $95 market price and $5 saving if it sold internally. So lowest transfer price would be equal to $90 if Cleaning and scraping division does not have any spare capacity. In this case selling division will not make any extra profit by selling product internally or externally. So they are happy to sale at this price.
However, in case of spare capacity lowest transfer price is equal to the marginal cost of production of a unit. So in this case
Marginal cost = Direct material + Direct labour + Variable overhead
= 18 + 12 + 30 = $60
So minimum acceptable transfer pricing for cleaning and scraping unit is $60 per unit.
This price will not be acceptable to the division manager as their total cost of production including the fix overhead is more than this price. Also this price is way lower than that of market price of the Cruden and by transferring the product at this price, performance of their unit is negatively seen by the management. Generally managerial compensation is tied up with the profit of the unit and by selling product at this cost their overall compensation will be low. So the manager will more be interested in selling the product at fair market price to the other unit.
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