Chapter 22 Homework Solution
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1 Chapter 22 Homework Solution B. 1. According to the general principle, since the external market exists the appropriate (optimal) transfer price would be the market price of $50. At any price lower than the external market price, Wood Division would not supply Paper Division. At a price higher than the external market price, Paper Division would not buy from Wood Division. 2a. From Requirement 1, we know that the market price of $50 is the optimal transfer price. However, in this requirement which do we choose--the market price for grade A or the market price for grade B wood? From the analysis below, we can see that if the $60 market price for grade A wood is used, Paper Division would show an operating loss. Using the $50 market price would allow Paper Division to break even. Clearly, a change in the transfer price does not change the total company operating income but does impact division performance. Wood Division would prefer the higher transfer price because its operating income increases from $1,000,000 to $2,000,000, especially if management is evaluated on divisional operating income. Paper Division would prefer the lower transfer price. Alternative 1: Required Internal Transfer at Transfer Price of $ 50 per unit Price Wood Paper Total Units per Unit Division Division Company Sales: Transfer from Wood Div to Paper Div 100,000 $ 50 $ 5,000,000 $ - $ 5,000,000 Sales from Paper Div to final market 100, ,000,000 12,000,000 Total sales $ 5,000,000 $ 12,000,000 $ 17,000,000 Variable costs: Incurred by Wood Division 100, ,000,000-2,000,000 Transfer price from Wood Division 100, ,000,000 5,000,000 Additional processing costs Paper Div 100, ,000,000 3,000,000 Contribution margin 3,000,000 4,000,000 7,000,000 Operating income $ 1,000,000 $ - $ 1,000,000
2 Alternative 2: Required Internal Transfer at Transfer Price of $ 60 per unit Price Wood Paper Total Units per Unit Division Division Company Sales: Transfer from Wood Div to Paper Div 100,000 $ 60 $ 6,000,000 $ - $ 6,000,000 Sales from Paper Div to final market 100, ,000,000 12,000,000 Total sales $ 6,000,000 $ 12,000,000 $ 18,000,000 Variable costs: Incurred by Wood Division 100, ,000,000-2,000,000 Transfer price from Wood Division 100, ,000,000 6,000,000 Additional processing costs Paper Div 100, ,000,000 3,000,000 Contribution margin 4,000,000 3,000,000 7,000,000 Operating income $ 2,000,000 $ (1,000,000) $ 1,000,000 b. The optimal transfer price in this case is the external market price for grade A wood ($60), even though no transfers will take place. This is the value of the wood that Wood Division produces. By using the market price for grade A wood as the transfer price, the company ensures that the managers understand the opportunity costs of using the wood from Wood Division in paper manufacturing. The manager loses the opportunity to sell it in the intermediate market, where the current price is $60. Thus, the Paper Division manager will face the same decision the company would if it were making the decision: use grade A wood at a cost of $60 or grade B wood at a cost of $50. The optimal transfer price is sending the correct "signal" to the subordinate managers. See analysis below:
3 Alternative 3: Allow divisional Managers to Decide Whether to Transfer Price Wood Paper Total Units per Unit Division Division Company Sales: Sales from Wood Div to intermediate mkt 100,000 $ 60 $ 6,000,000 $ - $ 6,000,000 Sales from Paper Div to final market 100, ,000,000 12,000,000 Total sales $ 6,000,000 $ 12,000,000 $ 18,000,000 Variable costs: Incurred by Wood Division 100, ,000,000-2,000,000 Purchase by Paper Div from market 100, ,000,000 5,000,000 Additional processing costs Paper Div 100, ,000,000 3,000,000 Contribution margin 4,000,000 4,000,000 8,000,000 Operating income $ 2,000,000 $ - $ 2,000,000
4 3. Some potential transfer prices can be disregarded immediately as suboptimal. At any transfer price below $20--the variable cost in Wood Division--no transfer will take place because Wood will lose money on each unit sold. Any transfer price above the final (paper) market price less the $30 variable processing cost of Paper Division will also not be optimal because Paper will not buy any wood. We have to determine the optimal transfer price between these two extremes. $50 Transfer Price A B C D Units transferred 100, , , ,000 Final market price $ 120 $ 70 $ 50 $ 40 Transfer price Texas Paper's decision: Revenue $ 12,000,000 $ 7,000,000 $ 5,000,000 $ 4,000,000 Variable Cost - Paper Division (100,000 x $30) 3,000,000 3,000,000 3,000,000 3,000,000 Contribution margin $ 7,000,000 $ 2,000,000 $ - $ (1,000,000) Wood Division's decision: Revenue ($50 transfer price from Paper Div) $ 5,000,000 $ 5,000,000 $ 5,000,000 $ 5,000,000 Contribution margin $ 3,000,000 $ 3,000,000 $ 3,000,000 $ 3,000,000 Paper Division's decision: Revenue (from sale to final market $ 12,000,000 $ 7,000,000 $ 5,000,000 $ 4,000,000 Variable Cost - transferred from Wood Division 5,000,000 5,000,000 5,000,000 5,000,000 Variable Cost - Paper Division further processing 3,000,000 3,000,000 3,000,000 3,000,000 Contribution margin $ 4,000,000 $ (1,000,000) $ (3,000,000) $ (4,000,000) Make transfer? Yes No No No
5 $20 Transfer Price (Variable cost in Wood Division) A B C D Units transferred 100, , , ,000 Final market price $ 120 $ 70 $ 50 $ 40 Transfer price Texas Paper's decision: Revenue $ 12,000,000 $ 7,000,000 $ 5,000,000 $ 4,000,000 Variable Cost - Paper Division (100,000 x $30) 3,000,000 3,000,000 3,000,000 3,000,000 Contribution margin $ 7,000,000 $ 2,000,000 $ - $ (1,000,000) Wood Division's decision: Revenue ($20 transfer price from Paper Div) $ 2,000,000 $ 2,000,000 $ 2,000,000 $ 2,000,000 Contribution margin $ - $ - $ - $ - Make transfer? Yes Yes Yes Yes Paper Division's decision: Revenue (from sale to final market) $ 12,000,000 $ 7,000,000 $ 5,000,000 $ 4,000,000 Variable Cost - transferred from Wood Division 2,000,000 2,000,000 2,000,000 2,000,000 Variable Cost - Paper Division further processing 3,000,000 3,000,000 3,000,000 3,000,000 Contribution margin $ 7,000,000 $ 2,000,000 $ - $ (1,000,000) In looking at the analysis, if the selling price of paper drops below $50 the Paper Division would have a negative CM. The Wood Division and the company as a whole would be okay as long as the final market price did not drop below %50. However, because of the profit issue with Paper Division, $50 would be optimal only as long as the final market price is $120 or higher. If we look at using the Wood Division variable cost of $20, we see that both divisions and the company as a whole would at least breakeven in regards to the CM if the final market price drops to $50. Keep in mind that the fixed costs are unavaidable and thereby irrelevant in this decision. There would also be no opportunity cost because if there is no intermediate market for the wood, there is no alternative use. Following this reasoning, it is easy to see that the only price that will work is the $20 variable cost for Wood Division.
6 4. Overall and divisional income for Texas Papers Wood Paper Total Division Division Company Units 100, ,000 Revenue $ 5,000,000 $ 12,000,000 $ 12,000,000 Variable costs Transfer - 2,000,000 c - Directly incurred 2,000,000 c 3,000,000 d 5,000,000 Contribution margin 3,000,000 7,000,000 7,000,000 Operating $ 1,000,000 $ 3,000,000 $ 1,000,000 a b b a 100,000 x $50 b 100,000 x $120 c 100,000 x $20 d 100,000 x $30 5. Answers will vary.
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