22-1

CHAPTER 22
MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING,
AND MULTINATIONAL CONSIDERATIONS


22-27 (2030 min.) Pertinent transfer price.

This problem explores the "general transfer-pricing guideline" discussed in the chapter.

1. No, transfers should not be made to Division B if there is no excess capacity in Division A.
An incremental (outlay) cost approach shows a positive contribution for the company as a whole.
Selling price of final product $300
Incremental costs in Division A $120
Incremental costs in Division B 150 270
Contribution (loss) $ 30

However, if there is no excess capacity in Division A, any transfer will result in diverting products from
the market for the intermediate product. Sales in this market result in a greater contribution for the
company as a whole. Division B should not assemble the bicycle since the incremental revenue Europa
can earn, $100 per unit ($300 from selling the final product $200 from selling the intermediate
product) is less than the incremental costs of $150 to assemble the bicycle in Division B.

Selling price of intermediate product $200
Incrementral (outlay) costs in Division A 120
Contribution (loss) $ 80

The general guideline described in the chapter is
Minimum
transfer price
=

_ Additional incremental costs

per unit incurred up
to the point of transfer
+

_ Opportunity costs
per unit to the
supplying division


= $120 + ($200 $120)
= $200, which is the market price


Market price is the transfer price that leads to the correct decision; that is, do not transfer to Division B
unless there are extenuating circumstances for continuing to market the final product. Therefore, B must
either drop the product or reduce the incremental costs of assembly from $150 per bicycle to less than
$100.

2. If (a) A has excess capacity, (b) there is intermediate external demand for only 800 units at $200,
and (c) the $200 price is to be maintained, then the opportunity costs per unit to the supplying division
are $0. The general guideline indicates a minimum transfer price of: $120 + $0 = $120, which is the
incremental or outlay costs for the first 200 units. B would buy 200 units from A at a transfer price of
$120 because B can earn a contribution of $30 per unit [$300 ($120 + $150)]. In fact, B would be
22-2
willing to buy units from A at any price up to $150 per unit because any transfers at a price of up to
$150 will still yield B a positive contribution margin.

Note, however, that if B wants more than 200 units, the minimum transfer price will be $200 as
computed in requirement 1 because A will incur an opportunity cost in the form of lost contribution of
$80 (market price, $200 outlay costs of $120) for every unit above 200 units that are transferred to
B.

The following schedule summarizes the transfer prices for units transferred from A to B.

Units Transfer Price
0200 $120$150
2001,000 $200

For an exploration of this situation when imperfect markets exist, see the next problem.

3. Division B would show zero contribution, but the company as a whole would generate a
contribution of $30 per unit on the 200 units transferred. Any price between $120 and $150 would
induce the transfer that would be desirable for the company as a whole. A motivational problem may
arise regarding how to split the $30 contribution between Division A and B. Unless the price is below
$150, B would have little incentive to buy.

Note: The transfer price that may appear optimal in an economic analysis may, in fact, be totally
unacceptable from the viewpoints of (1) preserving autonomy of the managers, and (2) evaluating the
performance of the divisions as economic units. For instance, consider the simplest case discussed
previously, where there is idle capacity and the $200 intermediate price is to be maintained. To direct
that A should sell to B at A's variable cost of $120 may be desirable from the viewpoint of B and the
company as a whole. However, the autonomy (independence) of the manager of A is eroded. Division
A will earn nothing, although it could argue that it is contributing to the earning of income on the final
product.

If the manager of A wants a portion of the total company contribution of $30 per unit, the
question is: How is an appropriate amount determined? This is a difficult question in practice. The price
can be negotiated upward to somewhere between $120 and $150 so that some "equitable" split is
achieved. A dual transfer-pricing scheme has also been suggested, whereby the supplier gets credit for
the full intermediate market price and the buyer is charged with only variable or incremental costs. In
any event, when there is heavy interdependence between divisions, such as in this case, some system of
subsidies may be needed to deal with the three problems of goal congruence, management effort, and
subunit autonomy. Of course, where heavy subsidies are needed, a question can be raised as to
whether the existing degree of decentralization is optimal.


22-28 (3040 min.) Pricing in imperfect markets. (Continuation of 22-27)

An alternative presentation, which contains the same numerical answers, can be found at the end of this
solution.

22-3
1. Potential contribution from external intermediate sale is
1,000 ($195 $120) $75,000
Contribution through keeping price at $200 is
800 $80. 64,000
Forgone contribution by transferring 200 units $11,000

Opportunity cost per unit to the supplying division by transferring internally:


200
000 , 11 $
= $55

Transfer price = $120 + $55 = $175

An alternative approach to obtaining the same answer is to recognize that the incremental or outlay cost
is the same for all 1,000 units in question. Therefore, the total revenue desired by A would be the same
for selling outside or inside.

Let X equal the transfer price at which Division A is indifferent between selling all units outside
versus transferring 200 units inside.
1,000 ($195) = 800 ($200) + 200X
X = $175

The $175 price will lead to the correct decision. Division B will not buy from Division A because
its total costs of $175 + $150 will exceed its prospective selling price of $300. Division A will then sell
1,000 units at $195 to the outside; Division A and the company will have a contribution margin of
$75,000. Otherwise, if 800 units were sold at $200 and 200 units were transferred to Division B, the
company would have a contribution of $64,000 plus $6,000 (200 units of final product $30), or
$70,000.

A comparison might be drawn regarding the computation of the appropriate transfer prices
between the preceding problem and this problem:



Minimum
transfer price
=

_ Additional incremental costs

per unit incurred up
to the point of transfer
+

_ Opportunity costs
per unit to
Division A


Perfect markets: = $120 + (Selling price Outlay costs per unit)
= $120 + ($200 $120) = $200

Imperfect markets: = $120 +
Marginal revenues Outlay costs
Number of units transferred


= $120 +
200
$24,000 $35,000
b a

= $175
a
Marginal revenues of Division A from selling 200 units outside rather than transferring to Division B
22-4
= ($195 1,000) ($200 800) = $195,000 $160,000 = $35,000.
b
Incremental

(outlay) costs incurred by Division A to produce 200 units
= $120 200 = $24,000.

Therefore, selling price ($195) and marginal revenues per unit ($175 = $35,000 200) are not
the same.

The following discussion is optional. These points should be explored only if there is sufficient
class time:

Some students will erroneously say that the "new" market price of $195 is the appropriate transfer
price. They will claim that the general guideline says that the transfer price should be $120 + ($195
$120) = $195, the market price. This conclusion assumes a perfect market. But, here, there are
imperfections in the intermediate market. That is, the market price is not a good approximation of
alternative revenue. If a division's sales are heavy enough to reduce market prices, marginal revenue will
be less than market price.

It is true that either $195 or $175 will lead to the correct decision by B in this case. But suppose
that B's variable costs were $120 instead of $150. Then B would buy at a transfer price of $175 (but
not at a price of $195, because then B would earn a negative contribution of $15 per unit [$300
($195 + $120)]. Note that if B's variable costs were $120, transfers would be desirable:

Division A contribution is:
800 ($200 $120) + 200 ($175 $120) = $75,000
Division B contribution is:
200 [$300 ($175 + $120)] = 1,000
Total contribution $76,000


Or the same facts can be analyzed for the company as a whole:

Sales of intermediate product,
800 ($200 $120) = $64,000
Sales of final products,
200 [300 ($120 + $120)] = 12,000
Total contribution $76,000

If the transfer price were $195, B would not accept the transfer and would not earn any contribution.
As shown above, Division A and the company as a whole will earn a total contribution of $75,000
instead of $76,000.

2. a. Division A can sell 900 units at $195 to the outside market and 100 units to Division B, or
800 at $200 to the outside market and 200 units to Division B. Note that, under both
alternatives, 100 units can be transferred to Division B at no opportunity cost to A.
Using the general guideline, the minimum transfer price of the first 100 units [9011000] is:
TP
1
= $120 + 0 = $120

22-5
If Division B needs 100 additional units, the opportunity cost to A is not zero, because
Division A will then have to sell only 800 units to the outside market for a contribution of
800 ($200 $120) = $64,000 instead of 900 units for a contribution of 900 ($195
$120) = $67,500. Each unit sold to B in addition to the first 100 units has an opportunity
cost to A of ($67,500 $64,000) 100 = $35.

Using the general guideline, the minimum transfer price of the next 100 units [801900] is:
TP
2
= $120 + $35 = $155

Alternatively, the computation could be:

Increase in contribution from 100
more units, 100 $75 $7,500
Loss in contribution on 800 units,
800 ($80 $75) 4,000
Net "marginal revenue" $3,500 100 units = $35

(Minimum) transfer price applicable to first 100 units
offered by A is $120 + $0 = $120 per unit
(Minimum) transfer price applicable to next 100 units
offered by A is $120 + ($3,500 100) = $155 per unit
(Minimum) transfer price applicable to next 800 units = $195 per unit


b. The manager of Division B will not want to purchase more than 100 units because the units
at $155 would decrease his contribution ($155 + $150 > $300). Because the manager of
B does not buy more than 100 units, the manager of A will have 900 units available for sale
to the outside market. The manager of A will strive to maximize the contribution by selling
them all at $195.

This solution maximizes the company's contribution:

900 ($195 $120) = $67,500
100 ($300 $270) = 3,000
$70,500
which compares favorably to:

800 ($200 $120) = $64,000
200 ($300 $270) = 6,000
$70,000


ALTERNATIVE PRESENTATION (by James Patell)

1. Company Viewpoint

a: Sell 1,000 outside at $195 b: Sell 800 outside at $200, transfer 200
22-6
Price $195 Transfer price $200
Variable costs 120 Variable costs 120
Contribution $ 75 1,000 = $75,000 Contribution $ 80 800 = $64,000

Total contribution given up if transfer occurs
*

= $75,000 $64,000 = $11,000

On a per-unit basis, the relevant costs are:


Incremental costs to
point of transfer
+
Opportunity costs to
Division A of transfer
= Transfer price

$120 +
200
000 , 11 $
= $175


By formula, costs are:

]
1
1
1 Incremental costs
to point
of transfer
+

]
1
1
1 Lost opportunity to
sell 200 at $195, for
contribution of $75

]
1
1
1 Gain when 1st 800
sell at $200
instead of $195


= $120 +
200
75 $ 200

[ ]
200
800 ) 195 $ 200 ($


= $120 + $75 $20 = $175
*
Contribution of $30 per unit by B is not given up if transfer occurs, so it is not relevant here.

2. a. At most, Division A can sell only 900 units and can produce 1,000. Therefore, at least 100
units should be transferred, at a transfer price no less than $120. The question is whether or
not a second 100 units should be transferred.

Company Viewpoint

a: Sell 900 outside at $195 b: Sell 800 outside at $200, transfer 100
Transfer price $195 Transfer price $200
Variable cost 120 Variable cost 120
Contribution $ 75 900 = $67,500 Contribution $ 80 800 = $64,000


Total contribution forgone if transfer of 100 units occurs
= $67,500 $64,000 = $3,500 (or $35 per unit)


Incremental costs to
point of transfer
+
Opportunity costs to
Division A of transfer
= Transfer price

$120 + $35 = $155
22-7

b. By formula:

]
1
1
1 Incremental costs
to point
of transfer
+

]
1
1
1 Lost opportunity to
sell 100 at $195, for
contribution of $75

]
1
1
1 Gain when 1st 800
sell at $200
instead of $195


= $120 +
100
75 $ 100

100
] 800 ) 195 $ 200 [($

= $120 + $75 $40 = $155

Transfer Price Schedule (minimum acceptable transfer price)

Units Transfer Price
0100 $120
101200 $155
2011,000 $195



22-33 (30 min.) Transfer pricing, goal congruence.

1a. & b. As the following calculations show, if Johnson Corporation offers a price of $37 per cassette
deck, Sather Corporation should purchase the cassette decks from Johnson. If Johnson Corporation
offers a price of $43 per cassette deck, Sather Corporation should manufacture the cassette decks in-
house.


Transfer 10,000
cassette decks to
Assembly. Sell
2,000 in outside
market
(1)
Buy 10,000
cassette decks
from Johnson at
$37. Sell 12,000
cassette decks in
outside market
(2)
Buy 10,000
cassette decks
from Johnson at
$43. Sell 12,000
cassette decks in
outside market.
(3)
Incremental cost of Cassette Deck Division
supplying 10,000 cassette decks to
Assembly
$25 10,000; 0; 0



$(250,000)



$ 0



$ 0
Incremental costs of buying 10,000 cassette
decks from Johnson
$0; $37 10,000; $43 10,000


0


(370,000)


(430,000)
Revenue from selling cassette decks in outside
market
$35 2,000; 12,000; 12,000


70,000


420,000


420,000
Incremental costs of manufacturing cassette
decks for sale in outside market






22-8
$25 2,000; 12,000; 12,000 (50,000) (300,000) (300,000)
Revenue from supplying cassette-head
mechanism to Johnson
$18 0; 10,000; 10,000


0


180,000


180,000
Incremental costs of supplying cassette-head
mechanism to Johnson
$12 0; 10,000; 10,000


0


(120,000)


(120,000)
Net costs $(230,000) $(190,000) $(250,000)



At a price of $37 per cassette deck, the net cost of $190,000 is less than the net cost of
$230,000 if Sather Corporation made the cassette decks in-house. Hence, Sather Corporation should
outsource to Johnson.

At a price of $43 per cassette deck, the net cost of $250,000 is greater than the net cost of
$230,000 if Sather Corporation made the cassette decks in-house. Hence, Sather Corporation should
reject Johnsons offer.

2. For the Cassette Deck Division and the Assembly Division to take actions that are optimal for
Sather Corporation as a whole, the transfer price should be set at $41, calculated as follows:

The Cassette Deck Division can manufacture at most 12,000 cassette decks and is currently
operating at capacity. The incremental costs of manufacturing a cassette deck are $25 per deck. The
opportunity cost of manufacturing cassette decks for the Assembly Division is (1) the contribution
margin of $10 (selling price, $35 minus incremental costs $25) that the Cassette Deck Division would
forgo by not selling cassette decks in the outside market and (2) the contribution margin of $6 (selling
price, $18 minus incremental costs, $12) that the Cassette Deck Division would forgo by not being able
to sell the cassette-head mechanism to outside suppliers of cassette decks (such as Johnson). Thus, the
total opportunity cost of the Cassette Deck Division of supplying cassette decks to Assembly is $10 +
$6 = $16 per unit.

Using the general guideline,


Minimum transfer
price per cassette deck
=
division selling
the deck to cassette
per costs y Opportunit

transfer of point
the to up deck cassette
per cost l Incrementa
+

= $25 + $16 = $41

Note that, at a price of $41, Sather is indifferent between manufacturing cassette decks in-house
or purchasing them from an outside supplier. Each results in a net cost of $230,000. For an outside
price per cassette deck below $41, the Assembly Division would prefer to purchase from outside;
above it, the Assembly Division would prefer to purchase from the Cassette Deck Division.

When selling prices are uncertain, the transfer price should be set at the minimum acceptable
transfer price. For example, if the transfer price were set above the minimum transfer price at $42 per
cassette deck, say, and an outside supplier offered to supply the cassette decks at $41.50 per unit, the
Assembly Division would purchase the cassette deck from the outside supplier. In fact, as the following
calculations show, Sather Corporation, as a whole, would be better off had the Assembly Division
22-9
purchased the cassette decks from the Cassette Deck Division. The net cost to Sather Corporation if
the Cassette Deck Division transfers 10,000 cassette decks to the Assembly Division is $230,000 as
calculated in Column 1 of the table presented in requirement 1. If an outside supplier supplies cassette
decks at $41.50 each, we simply substitute $41.50 10,000 = $415,000 for the incremental costs of
buying 10,000 cassette decks in column 2 or 3 and leave everything else unchanged. This gives a higher
net cost of $235,000 to Sather Corporation as a whole.
It is only if the price charged by the outside supplier falls below $41 that Sather Corporation as
a whole is better off purchasing from the outside market. Setting the transfer price at $41 per unit
achieves goal congruence.



22-36 (4050 min.) Goal congruence, income taxes, different market
conditions.

1.
New Engine
Existing Engine
Used by Assembly
Selling price
Savings in purchase costs by making engines in-
house
Manufacturing costs:
Direct materials
Direct manufacturing labor
Variable manufacturing overhead
Total costs of manufacturing
Contribution margin from New Engine
Net savings in costs by making existing engine in-
house





$100
40
25
$375






165
$210




$125
50
25


$400




200


$200

If order for the new engine is accepted, San Ramon earns a
contribution margin of $210 2,000 units.
In this case, Engine Division will be in a position to supply only 2,000
units to Assembly, and Assembly will have to purchase 1,200 engines from
outside. The incremental cost of buying engines from outside is $200
1,200
Net benefit from accepting order


$420,000




240,000
$180,000
An alternative approach is to compare relevant costs of the accept order and reject order alternatives.

Accept Order Reject Order
22-10
1. Contribution margin from selling 2,000 units of new
engine, $210 2,000
2. Incremental cost of making and transferring 2,000 units
or 3,200 units of old engines, $200 2,000; $200
3,200
3. Incremental costs of purchasing 1,200 units from
outside, $400 1,200

$(420,000)


400,000

480,000
$460,000




$640,000


$640,000
San Ramon Corporation should
a. make 2,000 units of the new engine in the Engine Division
b. make 2,000 units of the existing engine for the Assembly Division
c. have the Assembly Division purchase 1,200 existing engines from the outside market
2. The options facing the Engine Division manager are (a) to sell 2,000 units of the special order
engine and make 2,000 units for the Assembly Division, or (b) to make 3,200 units for the Assembly
Division. The contribution margin per unit from accepting the special order is $210 per unit. Let the
transfer price be $X. Then, we want to find X such that
$210 2,000 + ($X $200) 2,000 = ($X $200) 3,200
($X $200)(3,200 2,000) = $420,000
$X $200 =
200 , 1
000 , 420 $
= $350
X = $550
For transfer prices below $550, the Engine Division gets more by selling 2,000 units outside and
transferring 2,000 units to Assembly Division. It will not transfer more than 2,000 units to Assembly
even though the transfer price is greater than the variable costs of manufacturing the existing engine,
$200 plus the contribution margin per unit from accepting the special order of $210 equal to $410
($500, say). Why? Because by transferring an additional 1,200 units (say), it will have to give up
$420,000 ($210 2,000) of contribution margin by not accepting the special order. The Engine
Division manager would be willing to transfer 2,000 units for which it has capacity (after fulfilling the
outside order) to the Assembly Division provided the transfer price covers the Engine Division's variable
costs. So, the range of transfer price that will induce the Engine Division manager to implement the
optimal solution in requirement 1 is:
TP $200 for the first 2,000 units
TP $550 for the next 1,200 units
The Assembly Division manager would be willing to buy from the Engine Division so long as the
transfer price is less than or equal to the price at which the Assembly Division can buy the engines on
the outside market.
TP $400
22-11
It will not buy the engines from the Engine Division if TP > $400. The range of TP that will result in
both managers favoring the optimal actions in requirement 1 are TPs that satisfy the respective
constraints described above.
$200 TP $400 for the first 2,000 units
TP = $550 for the next 1,200 units
This transfer-pricing scheme will induce both managers to transfer 2,000 units between the Engine and
Assembly Divisions, but no more. Because the Assembly Division manager is willing to pay no more
than $400 and the Engine Division manager is unwilling to transfer unless the transfer price is above
$550, no transfers will occur beyond the first 2,000 units.

3a. The full manufacturing costs of the engines transferred to the Assembly Division are:
Direct materials $125
Direct manufacturing labor 50
Variable manufacturing overheads 25
Fixed manufacturing overheads

,
_

engines 2,000 $260,000

2
$520,000

since the engines transferred to the Assembly
Division use up half the Engine Division's capacity 130
Total manufacturing cost $330
b. A transfer price of $330 is in the optimal range identified in requirement 2 and, so, will achieve the
optimal actions of selling 2,000 engines under the outside offer and transferring 2,000 engines to
the Assembly Division as identified in requirement 1. At the transfer price of $550 for the next
1,200 units, the Assembly Division will prefer to purchase engines at $400 from the outside
market.
c. One advantage of full cost transfer pricing is that it is useful for the firm's long-run pricing
decisions.
One disadvantage of full cost transfer pricing is that costs that are fixed for the corporation as a
whole look like variable costs from the viewpoint of the Assembly Division manager. This is
because, by choosing not to have a unit transferred from the Engine Division, the Assembly
Division manager would appear to save both the variable and fixed costs of the engine. This
could lead to suboptimal decisions.
4a. To minimize taxes, San Ramon should transfer the engines at the highest price it can, the market
price of $400. The Engine Division would pay no taxes on any income that it would report. By
setting the transfer price as high as possible, the Assembly Division would minimize the income it
would report and, hence, the taxes it would pay.
b. Yes, as in part 3b, the transfer price of $400 is also within the range identified in requirement 2
and so will achieve the outcome desired in requirement 1 (sell 2,000 engines under the outside
offer and transfer 2,000 engines to the Assembly Division).

22-12
5. San Ramon should use a transfer price of $400 for the first 2,000 units and $550 for the next
1,200 units when transferring engines from the Engine Division to the Assembly Division. This transfer
price minimizes tax payments for the San Ramon Corporation as a whole and also achieves goal
congruence. That is, at the transfer prices indicated, both Divisions will be content with the following
arrangement
a. The Engine Division will make 2,000 engines for outside customers and 2,000 engines for
the Assembly Division
b. The Assembly Division will take 2,000 engines from the Engine Division and 1,200 engines
from the outside market
Of course, the Assembly Division manager would like to negotiate a price lower than $400 (but
greater than $200) for the first 2,000 engines from the Engine Division, but this would increase San
Ramon's tax payments.
At a transfer price of $400, San Ramon can still evaluate each division's performance on the basis
of division operating income because the transfer price of $400 approximates the market prices for the
engines transferred from the Engine Division to the Assembly Division. Market-based transfer prices
give top management a reasonably good picture of the contributions of the individual divisions to overall
companywide profitability.