Fundamentals of Cost Accounting 3rd Edition by William N. Lanen, Shannon W. Anderson, Michael Maher

Exercise 30

Analyze Transfer Pricing Data

Valencia Products is a decentralized organization that evaluates divisional management based on measures of divisional contribution margin. Consumer Audio (CA) Division and Auto Electronics (AE) Division both sell audio equipment. CA focuses on home and personal audio equipment; AE focuses on components for automobile stereo systems. CA produces an audio player that it can sell to the outside market for $60 per unit. The outside market can absorb up to 70,000 units per year. These units require 3 direct labor-hours each.

If CA modifies the units with an additional hour of labor time, it can sell them to AE for $67.50 per unit. AE will accept up to 60,000 of these units per year.

If AE does not obtain 60,000 units from CA, it purchases them for $70 each from the outside. AE incurs $30 of additional labor and other out-of-pocket costs to convert the player into one that fits in the dashboard and integrates with the automobile’s audio system. The units can be sold to the outside market for $170 each.

CA estimates that its total costs are $825,000 for fixed costs, $12 per direct labor-hour, and $6 per audio player for materials and other variable costs besides direct labor. Its capacity is limited to 300,000 direct labor-hours per year.

Required

Determine the following:

a. Total contribution margin to CA if it sells 70,000 units outside.

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b. Total contribution margin to CA if it sells 60,000 units to AE.

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c. The costs to be considered in determining the optimal company policy for sales by CA.

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d. The annual contributions and costs for CA and AE under the optimal policy.

Step 1 of 15

Transfer pricing

Transfer pricing is the amount charged by one business unit of a company to another business unit for the products supplied. Each business unit is considered as separate responsibility centers and sale from one business unit to another business unit is consider as sale to an outsider. The sales based on transfer pricing are recorded in the accounting books of a firm and transfer prices are used for decision making, merchandise costing and performance assessment.

General transfer pricing rule

General pricing rule on setting optimal transfer pricing states that transfer pricing should be based on sum of: -

• outlay cost i.e. variable cost of producing a unit, plus

• opportunity cost of unit at the time of transfer i.e. difference between selling price in market and cost of internal transfer. It is actually loss of contribution by selling to internal business unit.