Chapter 19 – Strategic Performance Measurement—Investment Centers
19-49 (continued)
If Partial Sales to Division A are OK:
Division B should sell as many units as possible (in this case 50,000 of total demand) to outside
consumers. The remaining capacity (20%, or 12,500 units) should be used to provide Division A
with equipment.
2. Assuming that Division B limits its sales to Division A to the excess capacity of 12,500 units, the best
transfer price should fall in the range of $60 (Division B’s variable cost) and $80 (the outside
purchase cost to Division A). The two divisions should negotiate to determine the desired price in
this range. A price of $60 would allocate all the profit on the manufacture of the equipment to
Division A, while a price of $80 would allocate all the profit to Division B. Any price less than $60
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O/S
P=$130
B’s Capacity = 62,500
O/S
A
B
Chapter 19 – Strategic Performance Measurement—Investment Centers
19-50 Transfer Pricing; Strategy (45 minutes)
1. There are three options for the commercial division: buy from the internal supplier (the industrial
division), buy from Admiral Electric, or buy from Advanced Micro. The analysis follows, from the
perspective of FMI:
Buy inside from the industrial division:
Cost to FMI (assuming the Industrial Division is at full capacity):
Ind. Div.’s variable cost: $155 × 5,000 $775,000
Buy from Admiral Electric: Cost to FMI is $210. The contribution on sales to Admiral by the
industrial division is ignored because these sales are not contingent on the commercial division’s
decision.
The best transfer price, which would cause the buying division to autonomously make the correct
decision, would be to use the selling division’s market price of $205.
2. If the sales to Admiral Electric by the industrial division were contingent on the commercial
division’s decision, the relevant cost to FMI would be the price of $210 × 5,000 units (amount
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needed over the capacity of the industrial division). The net cost would then be the cost of $210 ×
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19-50 (continued)
3. The decision to have the commercial division buy outside to reduce overall costs is also consistent
with a strategy of decreasing the reliance of the commercial division on products from the industrial
division. If top management is unsure about the growth potential of the industrial division and has
declined any new investments there, perhaps the future holds capacity reduction or divestment of
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19-51 Strategy; Strategic Performance Measurement; Transfer Pricing (50 minutes)
1. Transfer prices based on cost are not appropriate as a divisional performance measure, and among
the reasons are because they:
2. Using the market price as the transfer price the contribution margin for both the Mining Division and
the Metals Division for the year ended May 31, 2016 is as calculated below.
Ajax Consolidated Calculation of
Divisional Contribution Margin
For the Year Ended May 31, 2016
Mining Division Metals Division
Selling Price $90 $150
Less: Variable costs
Direct materials 12 6
Direct labor 16 20
Manufacturing overhead (1) 24 10
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Notes:
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-51 (continued)
3. If the use of a negotiated transfer price was instituted by Ajax Consolidated, which also permitted the
divisions to buy and sell on the open market, the price range for toldine that would be acceptable to
both divisions would be determined as follows.
The Mining Division would prefer to sell to the Metals Division for the same price it can obtain on the
would benefit both divisions and the company as a whole.
4.A negotiated transfer price is the most likely to elicit desirable management behavior as it will:
Encourage the management of the Mining Division to be more conscious of cost control
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19-52 Transfer pricing; International Taxation; Ethics (30 minutes)
1. Because the tax rates are the same, there will be no effect on Target’s total tax burden from the
change in transfer price.
2. Now that the tax rates are different, Target has an opportunity to use transfer pricing to manage its
overall tax burden. The increase in the transfer price so that sales from the manufacturing unit to the
retail unit go from $300,000 to $360,000 would save Target $12,000 in taxes:
Taxes before the change in transfer price:
3. Most tax lawyers and accountants would call this good business and see no ethical issue. Others
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balance, it is most likely that tax treaties and tax policies and procedures within the major trading
countries have limited to a large extent the degree to which any multinational can reduce its tax
liability in this way. Most countries for example would insist on the “arm’s
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Chapter 19 – Strategic Performance Measurement—Investment Centers
19-53 Transfer Pricing—International Example (45-50 Minutes)
1. Combined (i.e., world-wide) after-tax income per unit:
Country A Country B
Subsidiary Parent Consolidated
Revenue/Unit = $200.00 $300.00 $300.00
Cost/Unit = $100.00 $200.00 $100.00
2. Revised selling price, subsidiary to parent company = $280.00:
Country A Country B
Subsidiary Parent Consolidated
Revenue/Unit = $280.00 $300.00 $300.00
Cost/Unit = $100.00 $280.00 $100.00
3. In this situation (i.e., where the income tax rate is the same in Country A as it is in Country B), then
the transfer price has no impact on the total amount of tax paid by the entity (as a whole) on the sale