Problem 1

Gamma Division of Vaughn Corporation produces electric motors, 20% of which are sold to Vaughan's Omega
Division and 80% to outside customers. Vaughn treats its divisions as profit centers and allows division
managers to choose whether to sell to or buy from internal divisions. Corporate policy requires that all
interdivisional sales and purchases be transferred at variable cost. Gamma Division's estimated sales and
standard cost data for the year ended December 31, based on a capacity of 60,000 units, are as follows:

Omega Outsiders
Sales $ 660,000 $5,760,000
Less: Variable costs 660,000 2,640,000
Contribution margin $ ---- $3,120,000
Less: Fixed costs 175,000 900,000
Operating income $ (175,000) $2,220,000
(loss)

Unit sales 12,000 48,000

Gamma has an opportunity to sell the 12,000 units shown above to an outside customer at $80 per
unit. Omega can purchase the units it needs from an outside supplier for $92 each.

Required:

A. Assuming that Gamma desires to maximize operating income, should it take on the new customer
and discontinue sales to Omega? Why? (Note: Answer this question from Gamma's perspective.)
B. Assume that Vaughn allows division managers to negotiate transfer prices. The managers agreed
on a tentative price of $80 per unit, to be reduced by an equal sharing of the additional Gamma
income that results from the sale to Omega of 12,000 motors at $80 per unit. On the basis of this
information, compute the company's new transfer price.

Answer:

A. Yes. Gamma is currently selling motors to Omega at a transfer price of $55 per unit ($660,000 ÷
12,000 units). A price of $80 to the new customer will increase Gamma Division's operating income
by $300,000 [($80 - $55) x 12,000 units].

B. The additional operating income to Gamma is $300,000 [($80 - $55) x 12,000 units]. Splitting this
amount equally results in a new transfer price of $67.50, calculated as follows:

Transfer price before reduction $80.00

Less: Omega's per-unit share of additional
income [($300,000 x 50%) ÷ 12,000 units] 12.50
New transfer price $67.50
Problem 2

. Sonoma Corporation is a multi-divisional company whose managers have been delegated full profit
responsibility and complete autonomy to accept or reject transfers from other divisions. Division X
produces 2,000 units of a subassembly that has a ready market. One of these subassemblies is
currently used by Division Y for each final product manufactured, the latter of which is sold to outsiders
for $1,600. Y's sales during the current period amounted to 2,000 completed units. Division X charges
Division Y the $1,100 market price for the subassembly; variable costs are $850 and $600 for Divisions
X and Y, respectively.

The manager of Division Y feels that X should transfer the subassembly at a lower price because Y is
currently unable to make a profit.

Required:
A. Calculate the contribution margins (total dollars and per unit) of Divisions X and Y, as well as the
company as a whole, if transfers are made at market price.
B. Assume that conditions have changed and X can sell only 1,000 units in the market at $900 per
unit. From the company's perspective, should X transfer all 2,000 units to Y or sell 1,000 in the
market and transfer the remainder? Note: Y's sales would decrease to 1,000 units if the latter
alternative is pursued.

LO: 6, 7 Type: A

Answer:

A Division X Division Y Company

.
Sales at $1,600 $ 3,200,000 $ 3,200,000
Transfers at $1,100 $ 2,200,000 (2,200,000)
Less: Variable costs
at $850 (1,700,000)
at $600                    (1,200,000 (2,900,000
Contribution margin $ 500,000 $ (200,000) $ 300,000

Unit contribution margin $ 250 $ (100) $ 150

B Alternative no. 1: Transfer 2,000 units to Division Y:

.
Company sales (2,000 x $1,600) $3,200,000
Less: Variable costs [2,000 x $850) + (2,000 x $600)] 2,900,000
Contribution margin $ 300,000

Alternative no. 2: Sell 1,000 units in the open market and transfer 1,000 units to Y:

Company sales [(1,000 x $900) + (1,000 x $1,600)] $2,500,000

Less: Variable costs [(2,000 x $850) + (1,000 x $600)] 2,300,000
Contribution margin $ 200,000

Division X should transfer all 2,000 units to Division Y to produce an additional $100,000 ($300,000
- $200,000) of contribution margin.
Problem 3

Kendall Corporation has two divisions: Phoenix and Tucson. Phoenix currently sells a condenser to
manufacturers of cooling systems for $520 per unit. Variable costs amount to $380, and demand for this
product currently exceeds the division's ability to supply the marketplace.

Kendall is considering another use for the condenser, namely, integration into an enhanced refrigeration
system that would be made by Tucson. Related information about the refrigeration system follows.

Selling price of refrigeration system: $1,285

Additional variable manufacturing costs required: $820
Transfer price of condenser: $490

Top management is anxious to introduce the refrigeration system; however, unless the transfer is made, an
introduction will not be possible because of the difficulty of obtaining condensers in the quality and quantity
desired. The company uses responsibility accounting and ROI in measuring divisional performance, and
awards bonuses to divisional management.

Required:

A. How would Phoenix's divisional manager likely react to the decision to transfer condensers to
Tucson? Show computations to support your answer.
B. How would Tucson's divisional management likely react to the $490 transfer price? Show
computations to support your answer.
C. Assume that a lower transfer price is desired. What parties should be involved in setting the new
price?
D. From a contribution margin perspective, does Kendall benefit more if it sells the condensers
externally or transfers the condensers to Tucson? By how much?

Answer:

A. The Phoenix divisional manager will likely be opposed to the transfer. Currently,
the division is selling all the units it produces at $520 each. With transfers taking
place at $490, Phoenix will suffer a $30 drop in sales revenue and profit on each
unit that is sent to Tucson.

B. Although Tucson is receiving a $30 "price break" on each unit purchased from
Phoenix, the $490 transfer price would probably be deemed too high. The reason:
Tucson will lose $25 on each refrigeration system produced and sold.

Sales revenue $1,285

Less: Variable manufacturing costs $820
Transfer price paid to Phoenix 490 1,310
Income (loss) $ (25)

C Kendall uses a responsibility accounting system, awarding bonuses based

. on divisional performance. The two divisional managers (or their
representatives) should negotiate a mutually agreeable price.
 D Kendall would benefit more if it sells the condenser externally. Observe
. that the transfer price is ignored in this evaluation—one that looks at the
firm as a whole.

Produce Produce Condenser;

Condenser; Sell Transfer; Sell
Externally Refrigeration System
Sales revenue $520 $1,285
Less: Variable cost
$380; $380 + $820 380 1,200
Contribution margin $140 $ 85

Problem 4

Cheney Corporation produces goods in the United States, to be sold by a separate division located in Italy.
More specifically, the Italian division imports units of product X34 from the U.S. and sells them for $950 each.
(Imports of similar goods sell for $850.) The Italian division is subject to a 40% tax rate whereas the U.S. tax
rate is only 30%. The manufacturing cost of product X34 in the United States is $720. Furthermore, there is a
10% import duty, computed on the transfer price, that will be paid by the Italian division and is deductible
when computing Italian income.

Tax laws of the two countries allow transfer prices to be set at U.S. manufacturing cost or the selling prices of
comparable imports in Italy.

Required:

Analyze the profitability of the U.S. division and the Italian division to determine whether Cheney as a whole
would be better off if transfers took place at (1) U.S. manufacturing cost or (2) the selling price of comparable
imports.

Answer:

Alternative no. 1: Transfer at U.S. manufacturing cost

United States: $720 - $720 = $0

Italy: $950 - $720 - ($720 x 10%) = $158; $158 - ($158 x 40%) = $94.80
Cheney Corporation: $0 + $94.80 = $94.80

Alternative no. 2: Transfer at selling price of comparable imports

United States: $850 - $720 = $130; $130 - ($130 x 30%) = $91

Italy: $950 - $850 - ($850 x 10%) = $15; $15 - ($15 x 40%) = $9
Cheney Corporation: $91 + $9 = $100

Alternative no. 2 would be more profitable: $100.00 vs. $94.80.

Problem 5

Walker, Inc., has a Pennsylvania-based division that produces electronic components, with a very strong
domestic market for circuit no. 222. The variable production cost is $140, and the division can sell its entire
output for $190. Walker is subject to a 30% income tax rate.

Alternatively, the Pennsylvania division can ship the circuit to a division that is located in Mississippi, to be
used in the manufacture of a global positioning system (GPS). Information about the global positioning system
and Mississippi's costs follow.

Selling price: $380

Circuit shipping and handling fees to Mississippi: $10
Labor, overhead, and additional material costs of GPS: $120

Required:

A. Assume that the transfer price for the circuit was $160. How would Pennsylvania's divisional
manager likely react to a corporate decision to transfer the circuits to Mississippi? Why?
B. Calculate Pennsylvania income, Mississippi income, and income for the company as a whole if the
transfer took place at $160 per circuit.
C. Assuming that transfers took place at a price higher than $160, would the revised price increase,
decrease, or have no effect on Walker's income? Briefly explain.
D. Assume that Walker moved its GPS production facility to a division located in Germany, which is
subject to a 45% tax rate. The transfer took place at $180. Shipping fees (absorbed by the
overseas division) doubled to $20; the German division paid an import duty equal to 10% of the
transfer price; and labor, overhead, and additional material costs were $150 per GPS. If the
German selling price of the GPS amounted to $450, calculate Pennsylvania income, German
income, and income for Walker as a whole.
E. Suppose that U.S. and German tax authorities allowed some discretion in how transfer prices were
set. Given the difference in tax rates, should Walker attempt to generate the majority of its income
in Pennsylvania or Germany? Why?

Answer:

A. The manager would be unhappy, as the division is being forced to take a "hit" of $30 per circuit
($190 vs. $160).

B. Pennsylvania: $160 - $140 = $20; $20 - ($20 x 30%) = $14

Mississippi: $380 - $10 - $120 - $160 = $90; $90 - ($90 x 30%) = $63
Walker, Inc.: $14 + $63 = $77

C. Walker's income is unaffected, as the transfer price is a wash between the divisions. In other
words, Pennsylvania's revenue is offset by Mississippi's cost.

D. Pennsylvania: $180 - $140 = $40; $40 - ($40 x 30%) = $28

Germany: $450 - $20 - $150 - $180 - ($180 x 10%) = $82; $82 - ($82 x 45%) = $45.10
Walker, Inc.: $28.00 + $45.10 = $73.10

E. Tax rates are lower in the U.S. than in Germany (30% vs. 45%). Thus, Walker would benefit if it
generated the majority of its income in Pennsylvania.