Transfer Pricing
Industrial Resources Company has two divisions that are involved in the internal transfer of products. The Mining Division refines a material called TZT, which is then transferred to the Metals Division. The TZT is processed into an alloy by the Metals Division, and the alloy is sold to customers at $150 per unit. The Mining Division is currently required by Industrial Resources Company to transfer its total yearly output of 400,000 units of TZT to the Metals Division at total actual manufacturing cost plus 10%. Unlimited quantities of TZT can be purchased and sold on the open market at $90 per unit. The Mining Division would incur a variable selling cost of $5 per unit if it sells on the open market. Brian Jones, manager of the Mining Division, is unhappy with having to transfer the entire output of TZT to the Metals Division at 110% of cost. In a meeting with management, he commented: "Why should my division be required to sell to the Metals Division at less than market price? My division is subsidising the profitability of the Metals Division. We should be allowed to charge the market price".
The following table shows the detailed unit cost structure for both the Mining and Metals Divisions during the most recent year:
|
|
Mining Division
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Metals Division
|
|
Transfer price from Mining Division
|
-
|
$66
|
|
Direct material
|
$12
|
6
|
|
Direct labour
|
16
|
20
|
|
Manufacturing overhead
|
32
|
25
|
|
Total cost per unit
|
$60
|
$117
|
Manufacturing overhead cost in the Mining Division is 25 per cent fixed and 75 per cent variable. Manufacturing overhead cost in the Metals Division is 60 per cent fixed and 40 per cent variable.
Required:
1. Explain why the transfer prices based on actual costs are not appropriate as the basis for divisional performance measurement.
2. Using the market price as the transfer price, determine the contribution margin for both the Mining Division and the Metals Division.
3. If Industrial Resources Company were to introduce the use of negotiated transfer prices and allow divisions to buy and sell on the open market, determine the price range for TZT that would be acceptable to both the Mining Division and the Metals Division. Explain your answer.
4. Identify which one of the three types of transfer prices (cost-based, market-based or negotiated) is most likely to elicit desirable management behaviour at the Company. Explain your answer.