Chapter 21 : Product Transfers Within A Company

CHAPTER 21

PRODUCT TRANSFERS WITHIN A COMPANY PAGE 1

Chapter 21 : Product Transfers Within A Company

LEARNING OBJECTIVESAfter studying this chapter, you will be able to:

1. Distinguish between components made in cost centers and intermediate products made in profit centers.

2. Understand the management accounting system's goals for transfer costing and transfer pricing.

3. Determine how the different cost and price options can affect managerial decision making, planning, cost management, and performance evaluation.

INTRODUCTIONA transfer simply involves moving a component part of a product from one responsibility center (RC) to another within a company. Most products consist of many component parts. Some of these parts can be sold as products themselves, rather than being used to make a “final” product in a different RC. Thus, there are two types of parts that can be transferred: parts that are not sold to outside customers (compo-nents), and parts that can be sold to outside customers. In economics, parts that can be sold or transferred are called intermediate products.

Cost centers within a factory produce components. In planning, they need to budget standard costs. In con-trol and evaluation, they are accountable for keeping costs within the standards budgeted (i.e., not incur-ring cost variances). When transferring components, the issue is, “What cost should be used for a component transferred to or from another RC?” For example, if a manager uses components made by other RCs, then she needs to know what they will cost in budgeting her product's cost.

A number of different cost options can be used. Actual cost or standard cost could be chosen. With each of these options, the cost could be based on variable costing or absorption costing. Which of these cost options will best help cost center managers budget, control operations, and evaluate performance?

Some managers may be allowed to sell what they make rather than just transferring it to another RC as an intermediate product. Managers who have sales responsibilities are called profit center managers. Now the management accounting information must help the manager making the intermediate product determine whether to sell it or transfer it. This profit center manager's question is, “Which customer (an outside cus-tomer or the next RC) will allow me to make the most profit?”

The management accounting system must also help the manager who needs the intermediate product to decide whether to buy it from the other manager or from an outside supplier. The question this manager wants to answer is, “Which supplier (an outside source or the other RC) will minimize my cost of getting this part?”

The company's upper management also needs information about transfers between profit centers, because of its concern with maximizing the company's overall profit. This information concerns whether the inter-mediate product was transferred when this transfer should have increased corporate profit. Upper manage-ment will also want to know whether the extra profit that should have resulted was actually realized.

Page 2 COST AND MANAGEMENT ACCOUNTING

TRANSFERS FROM COST CENTERSThe different types of transfers that a company might make are illustrated in the Yard Equipment Company situation in Exhibit 21-1. Yard Equipment Company is organized into a number of RCs that are called divi-sions. The Braxton Division makes motors that can be used in different products manufactured by Yard Equipment Company. The Clipper Division makes one of these products, lawn mowers. Other RCs make products such as grass trimmers, edgers, blowers, and so forth.

YARD EQUIPMENT COMPANY'S GOALS FOR THE DIVISIONSWhat are the responsibilities of the Braxton manager? She should produce quality motors on time for the needs of Clipper and the other product divisions. She should also budget motor production costs and con-trol costs on a day-to-day basis, avoiding unfavorable cost variances. Yard Equipment Company has for-mally designed the Braxton Division to be a cost center, in which the manager is only responsible for product quality, cost, and quota.

The Clipper manager also needs to budget and control the costs of making lawn mowers. Because each lawn mower needs a motor, he has to budget the cost of a motor along with the other manufacturing cost elements. The Clipper manager has an added responsibility, though. In addition to budgeting and con-trolling costs, he has to budget sales because the Clipper Division is a profit center. The lawn mowers' sales price has to be high enough to cover all the budgeted costs, including motors, as well as yielding the target profit Yard Equipment Company desires.

From Yard Equipment Company's standpoint, the cost used for a transferred motor must motivate the Braxton manager to control her production costs. It must also provide the company with a way to evaluate her cost control performance. Additionally, the transfer cost should allow the Clipper Division manager to budget motor costs for lawn mower production.

TRANSFER COSTING OPTIONSA transfer cost is the value used in the accounting system to record required transfers from production cost centers. In recommending a transfer cost to the managers involved, the management accountant has to consider three issues.

• Should the value be based upon the component's sales price or cost? • If cost is used, should it be the component's actual or standard cost?• If cost is used, should it be calculated by the variable or absorption costing method?

In this situation, Braxton is a cost center. It makes motors that are transferred to the other product divi-sions. Because it is a cost center, Braxton does not sell motors to customers outside the company. All motors are transferred to the other divisions to be used only in Yard Equipment's products.

Exhibit 21-2a presents Braxton's standard costs and actual costs, along with the number of motors bud-geted and actually produced in May. In May, Braxton's variable cost variances averaged $10 per motor unfavorable, and there was an unfavorable fixed overhead budget variance of $1,000 (averaging another $10 per motor). If the actual cost of $200 per motor is used to transfer motors, Yard Equipment Company's goals may not be realized. The Braxton manager has little incentive to control her costs if she knows that whatever the actual cost ends up being, it will be transferred to the Clipper Division. In other words, all

Exhibit 21 -1 Yard Equipment Company Responsibility Centers

Braxton

Other RCs

Clipper

Other RCs

motors

other products

lawn mowers

other products

external marketsfor finished products

Yard Equipment Company

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$20 per motor of her cost variances will be “buried” in the cost of the motors transferred and, thus, in the cost of the lawn mowers.

If all the cost variances are included in the transfer cost of the motor, the company will have a harder time evaluating both managers' performance. In this example, the Clipper manager budgeted $180 for a motor (its standard absorptive manufacturing cost), but motors were transferred at the actual cost of $200 each. The result is a $20 per motor unfavorable motor purchase price variance for the Clipper Division.1 The $2,000 price variance is more than 11 percent over budget ($20 / $180 = 11.11%). A variance this high will probably be investigated by the Clipper manager, who will then “appeal” it to upper management, claiming that the variance is not his responsibility and that he should not be held accountable for it in his performance evaluation. Upper management will then go to the Braxton manager and spend considerably more time trying to resolve this issue and correctly assign responsibility and evaluate performance.

What if all the major components of a lawn mower are made in various divisions and transferred to the Clipper Division? If their actual costs are used as the transfer costs, then the cost of the lawn mower will include all the cost variances from all the supplying divisions. To evaluate the performance of each man-ager, Yard Equipment Company needs to know which variances belong with each component, but because all the variances are hidden in the lawn mower's cost, it will not be easy to identify them and, thus, to eval-uate each manager properly.

The Clipper Division manager will also have a harder time trying to budget his costs, as he will not know what cost to use for motors until they are transferred. By then it may be too late to adjust the lawn mower's sales price for the different (higher) motor cost. Customers expect the sales price to be the same from month to month.

The company needs a transfer cost that can isolate cost variances for each division. The management accounting system can provide this information by transferring motors at their standard absorptive manu-facturing cost, shown in the following T-account of Braxton's cost flows:

The $2,000 debit balance remaining in the Braxton Division's WIP general ledger account represents the sum of the May cost variances. The Braxton manager knows she will be responsible for these variances, as she is responsible for this account. Having this responsibility should motivate her to control motor produc-tion costs. By isolating the manager's variances within her account, Yard Equipment Company will be bet-ter able to evaluate her (and the other managers') performance. Finally, by knowing that motors will be transferred at $180,000, the Clipper Division manager will be better able to budget the costs of making lawn mowers.

Should the standard variable or absorptive cost be used? In this example, the standard absorptive manufac-turing cost of $180 has been used. When building the cost of a lawn mower, all production costs need to be included so that an adequate markup and sales price result. Further, by including the budgeted fixed over-head in the transferred cost of the lawn mower, the $1,000 fixed overhead spending variance remains in the Braxton Division's account, improving performance evaluation and cost management motivation.

When the standard variable costing method is used, the fixed overhead is not included in the per-unit motor cost. All the fixed overhead of the company is journalized to a separate fixed overhead account and

Exhibit 21 -2 Braxton's Budgeted and Actual Data for May

Standard Costs Per Unit

Totals Actual Costs Per Unit Totals

Variable cost $100 10,000 $110 $11,000Fixed costs 80 8,000 90 9,000Total costs $180 $18,000 200 $20,000Production volume: 100 motors

1. From Chapter 8, a direct material spending (price) variance - actual motors purchased multiplied by (standard price - actual price). The difference between standard and actual motor “price” is $20 unfavorable. For 100 motors transferred, this is $2,000.

Work-in-process Inventory: Braxton DivisionActual costs are debited to the Costs transferred out to Clipper:

General Ledger account: $20,000 ($180 x 100 motors) $18,000Balance = $2,000


ultimately written off to cost of goods sold (at year-end) as a lump-sum amount. Thus, with a variable cost-ing system, it may be more difficult to trace fixed overhead spending and volume variances to the individ-ual RCs where they were caused.

MARKET PRICE-BASED TRANSFER COSTINGIt is theoretically possible for Clipper to obtain motors from an external supplier rather than from Braxton. If so, then there is a market price for motors that might serve as a transfer cost. The external market price for motors represents the opportunity cost to Clipper for obtaining motors. If the company discontinued the Braxton Division, then the market price would be the cost Clipper would have to budget for motors when establishing the standard cost of a lawn mower.

While market price may be an opportunity cost for obtaining motors, it is not a real cost. Remember that Clipper must get motors from Braxton, and Braxton must supply motors to Clipper. If market price were used as the transfer cost, then the cost of lawn mowers would be overstated, assuming Braxton's cost of making motors is less than the cost of buying motors from an external supplier. Also, market prices may change, which could make the Clipper Division manager's budgeting more difficult than if he used Brax-ton's standard cost.

Consider using market price to transfer motors to Clipper. Assume that Clipper can buy motors from an outside source at $250 each. The following T-account illustrates the cost flows for Braxton's general ledger account:

How should Yard Equipment Company's management interpret the $5,000 credit balance? If Clipper had bought the motors from an outside source, then Yard Equipment Company would have lost $7,000 in prof-its ($250 to buy - $180 to make = $70 per motor for 100 motors). In other words, because Braxton made the motors, the company saved $7,000, less, of course, the $2,000 in unfavorable cost variances Braxton had in May. In effect, the transfer resulted in $5,000 of extra profits for Yard Equipment Company.

But did Braxton really make $5,000 in profits for Yard Equipment Company? No. In fact, the cost of lawn mowers is $5,000 less than what is shown in the accounting system.

Using $250 as the cost of motors overstated the real cost of a lawn mower ($200 as shown in Exhibit 21-2a). By using market price, Braxton becomes a pseudo profit center in the accounting system. If the accounting system for Yard Equipment Company produces a segmented income statement, then the Brax-ton Division would show a $5,000 profit, while the Clipper Division would show this $5,000 as an extra cost of lawn mowers. In reality, Braxton's profit is created at Clipper's expense! Braxton really does not sell motors for $250, and this manager has no control over outside prices for motors. Thus, she should not be given credit for this pseudo profit in her performance evaluation.

Using a transfer cost that is greater than the motor's cost is called “marking up” cost to determine a sales price. Adding any amount of markup to the cost of a motor when transferring will result in a reported profit for Braxton within the accounting system. Some companies set their transfer costing policies so that some

Work-in-process Inventory: Braxton DivisionActual costs are debited to the Costs transferred out to Clipper:General Ledger account: $20,000 ($250 x 100 motors) $25,000

Balance = $5,000

Lawn Mower Costs As Shown On Clipper's Books:Per Unit Totals

Motors transferred from Braxton $250 $25,000Other variable costs of lawn mower 140 14,000Fixed costs 9,000Total manufacturing costs $48,000

Yard Equipment Company's Real Costs:Per Unit TotalsMotors made by Braxton $200 $20,000Clipper's variable costs of lawn mower 140 14,000Fixed costs 9,000Total manufacturing costs $43,000

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markup is added to the cost of a motor. Whether this markup creates a transfer cost of $250 or some lesser amount, an unreal profit is reported for the supplying division. What is the purpose of marking up cost since it appears to inhibit performance evaluation and misstates the cost of the motor to the divisions using it?

Two reasons have been given. First, consider the situation faced by a multinational company. For exam-ple, making motors in Mexico is cheaper than making motors in California due to lower wage rates among other things. If motors are made in Mexico, then the cost of a lawn mower made in California will be lower and the lawn mower's profit higher. Of course, more profit means more income taxes. Assume that California's state income tax rate is higher than Mexico's federal tax rate. If the 100 motors made in May are “sold” from Braxton's Mexico plant to Clipper's California plant for $250 each, then $5,000 of the ulti-mate profit from lawn mowers will appear to be made (and taxed) in Mexico. This movement of $5,000 in profits to a lower tax region saves taxes for Yard Equipment Company, thus increasing the company's aftertax profit.

This is just one example of the importance of transfer costing policies for international companies. There are many other considerations, of course, which are also complex and serious. They are not covered in this book, but are covered in advanced tax and international accounting courses. It is important to note, how-ever, that the accountant has an ethical and social responsibility in choosing a transfer cost (or a transfer price for profit center transfers, discussed in the next section).

The second reason for using cost plus markup for transfer costing is that doing so creates a “profit respon-sibility” for the Braxton manager. Some accounting theorists argue that if a cost center manager is respon-sible for profit, then she will be able to “see the big picture” and act in the best interests of the company (i.e., make more goal-congruent decisions). In other words, she will act as if she owned her own company, making and selling motors. An argument can be made against this approach, though. If making a profit results in more goal-congruent decisions, why doesn't the company let the Braxton manager sell motors to real customers for real cash? Redesigning the company so that Braxton is a real profit center creates other problems, however. These are considered in the next section.

TRANSFERS FROM PROFIT CENTERSAssume Braxton Motors is reorganized from a cost center to a profit center. This means that the Braxton manager now sells motors to outside customers. What are Yard Equipment Company's goals with respect to transfers between Braxton and Clipper? These will vary depending upon whether Braxton is required to transfer to Clipper and Clipper to obtain motors from Braxton, or whether both managers are free to make the transfer decision themselves. Each situation will be considered next. Exhibit 21-2b includes the same cost information as in Exhibit 21-2a, along with new information needed to analyze these profit center sit-uations.

REQUIRED TRANSFERS FROM A PROFIT CENTERIf Braxton is required to transfer motors to Clipper, but free to sell motors not needed by Clipper to outside customers, then Braxton is partly a cost center and partly a profit center. To the extent that Braxton must provide all the motors Clipper needs, with the Braxton manager having no choice in the matter, it is a cost center. The Braxton manager is responsible for product quality, delivery to Clipper (and other RCs using motors), and production cost control.

However, Braxton also sells motors to external customers. Thus, it is a real profit center. The goals Yard Equipment Company sets for a profit center include those for a cost center and the additional goal of max-

Exhibit 21-2b Braxton's Budgeted and Actual Data for MayStandard Costs Actual Costs

per Unit Total Per unit totalsVariable costs $100 $10,000 $110 $11,000Fixed costs 80 8,000 90 9,000Total costs $180 $18,000 $200 $20,000Production Volume

Sales volume

100 motors

100 motors (80 transferred to Clipper and 20 sold to outside customers at $300 each.)


imizing profits from motor sales. The accounting system will now have to provide information that sup-ports both of the following:

• The managers' abilities to budget and control costs and assess profit potential of various sales opportuni-ties

• The evaluation of profit and cost performance by Yard Equipment Company's management

In this situation, Braxton is required to transfer motors to Clipper. From Yard Equipment Company's point of view, Braxton's primary responsibility is to supply Clipper. Only secondarily can it sell surplus motors externally. The accounting system will best support the information needs of managers if the management accountant treats this situation as a transfer costing issue. In the last section, three transfer cost options were considered: using a sales price versus the component's cost, using actual versus standard cost, and using absorption versus variable cost. As was true for transfers from cost centers, using standard absorp-tive manufacturing cost best supports the informational needs of management. This is illustrated in Exhibit 21-3.

Braxton's income statement reports the COGS (production costs) for all 100 motors and then subtracts the standard cost allowed for the 80 motors transferred out. This results in a net COGS for the 20 motors sold. As Exhibit 21-3 shows, Braxton's cost variances remain in Braxton's income statement. They are not “bur-ied” in the cost of the motors transferred to Clipper, which would happen if actual costs were used as the transfer cost.

.If motors were transferred at the $300 market price, then a $10,000 gross profit would be reported for Braxton, even though it only had a real gross profit of $400. This is shown in Exhibit 21-4.

The $10,000 gross profit reported for Braxton includes two components. After Braxton covers its cost vari-ances front the “real” gross profits made on motors sold to external customers, $400 of real gross profit remains (see Exhibit 21-3). The second component of the reported gross profit is due to the pseudo profit created by the transfer to Clipper. This equals $9,600 ($300 - $180 production cost = $120 per motor for 80 motors transferred). Reporting $10,000 in gross profits for Braxton may lead Yard Equipment Company's management to believe that the Braxton manager is doing a much better job than she really is.

Recommendation: Unless there is some overriding reason to create pseudo profits in the supplying divi-sion, when transfers are required, treat the supplying division as a cost center with respect to the intermedi-ate product transferred. Transferring at standard absorptive manufacturing cost allows the cost variances created by Braxton to remain within that responsibility center. These cost variances are not obscured by pseudo profits that would result from using a market price to record transfers. This helps management

Exhibit 21 -3 Gross Profit for Braxton Division

Budgeted Actual VariancesPer Unit Totals Per Unit Totals Per Unit Totals

Sales (20 motors sold) $300 $ 6,000 $300 $ 6,000 $ 0 $ 0<COGS>(100 motors produced) Variable

100 10,000 110 11,000 <10> <1,000>

Fixed 80 8,000 90 9,000 <10> <1,000><Transferred> (80 motors) 180 <14,400> 180 <14,400>Net COGS (20 motors) <180> <3,600> <280>* <5,600>* <l00>* <2,000>*Gross profit $120 $ 2,400 $ 20 $ 400 <$100> <$2,000>*Note: Production cost variances for all 100 motors averaged $20 per motor unfavorable. This $2,000 in cost variances had to be recovered by the gross profit made on the 20 motors sold externally. The $2,000 = $100 per motor sold reducing the actual gross profit per unit from $120 to $20.

Exhibit 21 -4 Gross Profit with Transfers at Market

Budgeted Actual VariancesPer Unit Totals Per Unit Totals Per Unit Totals

Sales (100 motors) $300 $30,000 $300 $30,000 $-0- $ -0-Variable 100 10,000 110 11,000 <10> <l,000>Fixed 80 8,000 90 9,000 <10> <1,000>COGS <180> <18,000> <200> <20,000> <20> <2,000>Gross profit $120 $12,000 $100 $10,000 <$20> <$2,000>

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evaluate the performance of the managers involved in the transfers. Proper evaluation and rewards should motivate Braxton's manager to control costs. The use of standard cost for transfer costing should also help Clipper's manager budget lawn mower costs and profits.

OPTIONAL TRANSFERS FROM A PROFIT CENTERTransfer costing is the setting of a cost for required transfers. A transfer price is an “internal” sales price for optional transfers of intermediate products from a profit center to other RCs. Two of the responsibili-ties of a profit center manager are to choose customers and set sales prices that will maximize profits. With respect to the transfer decision, this means that the Braxton manager can choose whether or not to “sell” motors to the Clipper manager. This also means that the Clipper manager can choose to “buy” motors from Braxton or other suppliers. Thus, a joint decision will be required. Both managers will have to mutually agree to transfer motors.

In the preceding analyses of required transfers, using the standard absorptive manufacturing cost as the transfer cost was recommended. Because this is an absorption cost, the analysis focused on cost of goods sold and gross profit. Gross profit is a subtotal in the functional form, absorption costing-based income statement (from Chapter 20).

As the situations switch to optional transfers from profit centers and transfer pricing, the analysis changes from an absorption costing perspective to variable costing and contribution margin analysis. In the follow-ing section, then, the emphasis will change to analyzing a transfer's effect on contribution margin per unit (CMU), contribution margin (CM), and segment margin (SM). This is consistent with the tools developed in Chapters 18, 19, and 20 for analyzing profit decisions and evaluating profit centers.

In fact, the transfer decision is simply a special sales order, make-or-buy, or sell-or-process-further deci-sion (all covered in Chapter 19), depending on which manager's perspective is being considered. The deci-sion to transfer requires incremental CVP analysis (Chapter 18). Performance evaluation uses segmented contribution margin-based income statements for the two divisions (Chapter 20).

The analysis becomes somewhat complex, however, because four different entities, each with its own profit, must be simultaneously considered. The entities involved, and the specific type of profit used for each one in the following discussions, are summarized below:

When discussing transfer pricing, these different profit terms will be used. To avoid confusion, it is important to remember that there will be a differential profit associated with the choice between transfer-ring or not. This differential profit will affect the CMU, CM, and SM of each division's income statement as well as the overall corporate profits.

A transfer price creates a CMU for each intermediate product transferred from the supplying division. Of course, as noted above, this also creates an extra cost far the division using the intermediate product. This raises a new set of concerns for Yard Equipment Company's management. As examples, consider the fol-lowing questions:

• How much extra CMU should the accounting system report for Braxton (and extra cost for Clipper) because of a transfer?

• Since a profit to one manager is a cost to the other manager, and they are both rewarded for maximizing their segment margins, how can Yard equipment Company minimize the conflict between them over the transfer price?

• Can a transfer pricing policy be created that will motivate the managers to transfer when doing so will increase overall corporate profits?

• How will the profit center managers be rewarded for making the right transfer decision?• How will the profit center managers know when to transfer (i.e., when a transfer creates a differential

profit for Yard Equipment Company)?• How will the company know if the predicted profit from a transfer was realized?

Obviously, the management accountant will have to deal with a number of complex and interesting issues when developing a transfer pricing policy for optional transfers between profit centers. These include

Entity Profit Measure UsedThe transfer decision itself: The transfer's differential profitThe selling and buying divisions: Each division's CMU, CM, and SMThe overall corporation: Overall corporate profits


motivational questions, reward and evaluation issues, reporting formats, and ethical issues. Each will be considered in the following sections.

TRANSFER PRICING POLICIES FOR OPTIONAL PROFIT CENTER TRANSFERS

Fundamentally, a transfer pricing policy has two goals:

• The accounting system should provide the relevant information the managers need to determine when a transfer will increase overall corporate profits.

• The accounting system should report on whether the transfer resulted in the anticipated differential profit.

In the following sections you will learn about a number of issues where transfer prices cause problems due to a specific way that North American and many other countries use transfer prices. However in Japan, these issues never arise, and in Sweden rarely. The difference is that in Japan a manager in never evaluated based on his or her unit’s performance and in Sweden a manager is not normally evaluated by his or her unit’s performance. It is only when the unit performance is used to evaluate managers that transfer prices cause difficulties.

DETERMINING AN OPTIONAL TRANSFER'S DIFFERENTIAL PROFITThe first goal for the management accounting system is to provide information that will indicate whether a transfer creates a differential profit for Yard Equipment Company. If so, then the two division managers should agree to transfer motors from Braxton to Clipper. The differential profit depends on the opportunity costs of the two managers. The opportunity costs, in turn, depend on the following:

• Whether Braxton has enough surplus capacity to fill Clipper's order• Whether any differential fixed costs will be needed if motors are transferred• Whether Clipper can purchase motors from another supplier

The following sections will first consider the situation in which Braxton has enough surplus capacity to make the motors Clipper needs. Then, the situations in which Braxton has no surplus capacity for the Clip-per order and only limited surplus capacity are examined. Next, the analysis will be expanded to include differential fixed costs. Finally, situations in which there are no other suppliers for motors will be consid-ered.

The second goal of the management accounting system is to report whether the differential profits were realized. This involves determining a transfer price and reporting any cost variances related to the transfer. The transfer price, in turn, depends upon how the managers will be rewarded for transferring an intermedi-ate product when doing so should increase Yard Equipment Company's overall profits. These issues will be discussed in later sections.

Consider the new relevant information needed to calculate opportunity costs and determine whether a dif-ferential profit results in these intermediate product transfer situations. To illustrate, assume that Braxton's production costs are the same as in the previous examples (Exhibit 21-2b). There also are other variable costs (selling and administrative) of $90 per motor when selling to regular (external) customers. It Braxton transfers motors to Clipper, though, it can save $15 per motor of these normal variable selling costs. This savings represents $5 in delivery costs and $10 in packaging costs. It is important to realize that for motors transferred within Yard Equipment Company, the variable costs will probably be different from the vari-able costs of normal motor sales to regular external customers. The relevant information is summarized in Exhibit 21-5.

SELLING DIVISION WITH SURPLUS CAPACITY SITUATION. In the first optional transfer situa-tion, Braxton is currently selling 100 motors to external customers at $300 each. Braxton has the capacity to produce 150 motors. The Clipper Division manager wants to purchase no more than 50 motors, so Brax-ton has sufficient surplus capacity to fill the Clipper order without giving up any normal external sales.

The Clipper manager has two alternatives: buy motors from Braxton, or buy from an outside supplier for $275 each. All other things being equal, his decision rule is to buy the cheaper motor. His decision is to “buy internally” (transfer) if the transfer price is less than or equal to the current external purchase price of $275. Obviously, he would accept a transfer price lower than $275 (i.e., $200, $100, or even free; the lower the price, the better from his point of view!). Thus, the $275 external purchase price is a ceiling transfer price because it is the maximum price the buying division manager is willing to pay for motors.

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Next, consider the Braxton manager. Her decision rule is to at least break even on an internal sale, so as to maintain her current segment margin. When she has enough surplus capacity for the transfer, her two alternatives are to sell to Clipper or not to produce these extra 50 motors at all because there is no other buyer for them. If there were other external customers, she would he selling more motors to them! The transfer price must be high enough to at least cover her “internal variable costs” of transferring, which are budgeted at $175 (Exhibit 21-5).2

Therefore, her decision is to sell to Clipper if the transfer price is greater than or equal to $175. However, the Braxton manager will accept a transfer price of $250, or $300, or more-the higher the price, the better from her viewpoint. Thus, she has a minimum acceptable price, but no maximum price. This floor trans-fer price is equal to her budgeted variable cost of $175 to produce and deliver an extra motor to Clipper.

Third, consider the motivations of Yard Equipment Company. Its decision rule (ceteris paribus) is to obtain motors at the cheapest cost. The company perceives two alternatives. It can make these extra motors (in the Braxton Division) for $175 or buy them (through the Clipper Division) from an outside source for $275. Obviously, the company wants a transfer, as this will yield a cost savings of $100 per motor.3 This is illustrated in Exhibit 21-6.

In this situation, Yard Equipment Company saves $100 per motor if Braxton transfers motors to Clipper. How is this $100 cost savings calculated? Looking at the bottom line of Exhibit 21-6, it is the ceiling transfer price minus the floor transfer price. More formally, it is the difference in the opportunity costs of the buying and selling divisions.

Clipper, the buying division, can purchase motors externally for $275 each. If he can buy motors for the same or less from Braxton, then he will want a transfer.4 Thus, the $275 external purchase price is the buy-ing division manager's opportunity cost. It costs the Braxton manager $175 to produce and deliver a motor to the Clipper Division. She will not want to do this unless the transfer price is at least $175, so that she

Exhibit 21 -5 Relevant Data for the Transfer Decision

Braxton Motors DivisionProduction data:

Current volume: 100 motors, all sold to external customersCapacity: 150 motors could be produced in a month

Standard costs Actual costsPer Unit Totals Per Unit Totals

Cost data:

Normal variable costs (for external sales): Production costs $100 $10,000 $110 $11,000Other variable costs 90 9,000 90 9,000Totals $190 $19,000 $200 $20,000Internal variable costs (for transfers): Production costs $100 $110Other variable costs 75 75Totals $175 $185Sales price: Motors sold to outside customers at $300Clipper Lawn Mower DivisionPurchase price for motors from external supplier: $275 eachOther variable costs of making lawn mowers: 140Sales price for lawn mowers: 600Place a paper clip on this page so that you can refer back to these amounts when reading the following sec-tions!

2. From her perspective, this is just a special-order situation, which was covered in Chapter 19.3. From the company's perspective, this is a simple make-or-buy decision as presented in Chapter 19.4. He is willing to pay the same price of $275 for transferred motors from Braxton because, even though he won't save any money, he may have greater control over the quality of the motors and they may be more likely to he delivered on time if they are produced within Yard Equipment Company.


breaks even on the transfer. Therefore, the selling division manager's opportunity cost is the internal vari-able cost associated with the transfer.

Thus, there is a range of transfer prices acceptable to both managers. This range is bounded by the ceil-ing and floor prices. If a range exists—in other words, if the ceiling is greater than the floor—then Yard Equipment Company will always realize a differential profit from transferring. If the accounting system provides this information to the managers, then they will know whether or not they should agree to transfer motors. In this situation, the managers should decide to transfer. This is only true, though, if Braxton has sufficient surplus capacity to fill the Clipper order. A modified analysis is needed if Braxton is operating at full capacity.

THE SELLING DIVISION AT FULL CAPACITY SITUATION. Consider a different situation in which Braxton is producing at maximum capacity for external sales. Now it is making all the motors it can (150 per month). The calculation of the floor changes because the Braxton manager's alternatives are dif-ferent from those in the surplus capacity situation. She can continue to sell every motor that can he made to normal external customers, or she can sell to Clipper instead. Again, her decision rule is to at least break even on the internal sale. In this case, break even means maintaining the same contribution margin she now has by selling all 150 motors to normal external customers.

She is currently budgeting for a $110 CMU per motor sold externally ($300 sales price - $190 normal vari-able costs = $110). Normal variable selling costs of $15 can be saved when selling internally ($90 com-pared to $75 in Exhibit 21-5). This savings can be passed along to Clipper by reducing the transfer price from the current sales price of $300 to $285. At this price, the CMU per motor on an internal sale will equal the current CMU on these same motors sold externally. As long as the manager can make the same CMU from selling to Clipper as she made from selling the same motors to other customers, she will be willing to transfer. She calculates the floor transfer price as follows:

To “test” whether this floor price is correct, she can do the following analysis:

Her minimum transfer price equals the variable costs of a transferred motor ($175) plus the CMU lost from not selling the motor to a normal customer ($110). This leads to another way to calculate the floor price. Let:

IVC = Internal variable costCMU = Contribution margin per motor lost by not selling to a normal customerDFC = Differential fixed cost per motor, if any exists, created by a transfer (a fixed cost that would not

exist with a normal sale)

Floor transfer price = IVC + CMU + DFC

Then:

With surplus capacity: $175= $175 + $0 + $0At full capacity: $285 = $175 + $110 + $0

When a differential fixed cost exists with a transfer, it should be unitized and added into the formula. This is covered in Exhibit 21-10 later. The benefit of this approach is that it provides one formula that can be

Exhibit 21 -6 The Transfer's Differential Profit When the Selling Division has Surplus Capacity

Range of transfer prices External purchase capacityCEILING: (determined by Clipper) External purchase price: $275.00FLOOR: (determined by Braxton) Internal variable cost: $175.00Variable costs saved by transferring: (for Yard Equipment Co.) Ceiling minus floor: $100.00

Floor transfer price when operating at full capacity

= Normal sales price - Normal variable costs saved by transferring

Current External Sales Proposed Internal SaleSales price $300 (Solve for this)

Less variable costs <190> <175>Contribution margin per motor $110 $110

Must have at least the same CMU

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used to calculate the floor in almost all situations.5 Any of the three methods just illustrated can be used to calculate the floor price. Choose the one that is easiest to understand.

The Clipper manager's decision, however, is not influenced by whether Braxton is operating at full capac-ity or has enough surplus capacity for the transfer. His decision rule is still not to pay more than the current external purchase price of $275. Thus, the ceiling transfer price remains the same as in the surplus capac-ity situation.

Will Yard Equipment Company realize a differential profit if motors are transferred, instead of sold exter-nally, when Braxton is at full capacity? As in the surplus capacity situation in Exhibit 21-6, the differential profit to Yard Equipment Company is the ceiling price minus the floor price. Since the ceiling price of $275 is less than the floor price of $285, this difference is negative. In other words, there is an opportunity cost to Yard Equipment Company of $10 per motor if motors are transferred.

One way to reconcile this calculation is by considering upper management's evaluation of this potential transfer. Yard Equipment Company views this as a sell-or-process-further decision. The motors can be sold now to external customers with an expected CMU of $110, or they can be processed further; that is, transferred to Clipper and used in the making of lawn mowers. Processing further (transferring) saves the company $100 in the cost of acquiring the motor ($175 budgeted cost to make and deliver from Braxton versus $275 cost for Clipper to buy externally). However, transferring means that Braxton will not be able to sell the motors to its normal customers. Thus, the $110 CMU from those sales will be lost. The net result to Yard Equipment Company is a $10 per motor loss. It saved $100 in the cost of each motor, but lost $110 per motor by not selling them now.6 In this case, Yard Equipment Company is better off if no transfer occurs. This is illustrated in Exhibit 21-7.

COMPARING THE SURPLUS AND FULL CAPACITY SITUATIONS. To compare the two selling division situations, Exhibits 21-6 and 21-7 are combined in Exhibit 21-8. This is called the “Transfer Pricing Matrix.”7

In comparing the two situations, it is important to determine the source of the motors to be transferred. When the selling division is operating at full capacity, the floor price is different from when the division has enough surplus capacity for the transfer, because the opportunities of the selling division manager are different.

However, the difference between the ceiling and floor of the transfer price range always determines the transfer's differential profit to the overall corporation. In this example, when Braxton has enough surplus capacity to fill Clipper's order, there is a $100 per motor differential profit to Yard Equipment Company if the transfer takes place. If Braxton is producing at maximum capacity for current external sales, transfer-ring will result in a differential loss of <$10>.

THE LIMITED CAPACITY SITUATION. What happens if Clipper wants more motors than the sur-plus capacity available in Braxton? For example, assume Clipper wants 75 motors. Referring back to Exhibit 21-5, Braxton only has the surplus capacity to produce 50 motors without giving up some of the 100 motors currently being sold. Thus, if Braxton transfers 75 motors, it will not be able to sell 25 motors to normal customers. This decision is a special-order situation with insufficient surplus capacity. By add-

5. This formula is from Ralph T. Benke, Jr., and James Don Edwards, Transfer Pricing: Techniques and Uses (New York: Institute of Management Accountants, formerly the National Association of Accountants, 1980), p. 11. With permission.6. This $10 per motor loss is a negative differential CMU for each motor transferred from Yard Equipment Company's perspective. A change in CMU filters down “penny-for-penny” into a change in CM, SM, and overall corporate profits.7. This presentation approach is adapted from M. Thomas, “A Matrix Approach to Transfer Pricing,” Journal of Accounting Education, 1991, pp. 137-147.

Exhibit 21 -7 The Transfer's Differential Profit When the Selling Division is at Full Capacity.

Range of transfer prices When Braxton has no surplus capacityCEILING: (determined by Clipper) External purchase price: $275.00FLOOR: (determined by Braxton) External sales price $300.00

Less variable costs saved: <15.00>$285.00

Transfer's differential contribution margin per motor: (for Yard Equipment Company)

Ceiling minus floor: <$10.00>


ing two lines to the bottom of the Transfer Pricing Matrix in Exhibit 21-8, the limited surplus capacity situ-ation can easily be evaluated. The calculation of the transfer's differential profit in this situation is shown in Exhibit 21-9.

In this case, transferring the first 50 motors increases overall corporate profits by $5,000. However, trans-ferring the last 25 motors will cost the company $250 in profits it could have had if it had not transferred them and instead had sold them to regular customers. The net change in overall corporate profits from transferring all 75 motors is the sum of these amounts ($5,000 - $250 = $4,750). Since Yard Equipment Company will be $4,750 better off if a transfer takes place, the managers should decide to transfer. Obvi-ously, if it is possible to purchase only 25 motors from Clipper's external source at a price of $275 each, then 50 motors should be transferred and 25 purchased. In those situations in which it is not possible to purchase smaller quantities at the same price, then the Exhibit 21-9 analysis is appropriate.

TRANSFERS THAT INCUR DIFFERENTIAL FIXED COSTS. So far, the only differential costs from transferring were the variable costs Braxton would have to incur to make and deliver motors to Clip-per. But Clipper now wants 20 motors with a special name plate stamped on them. This will require Brax-ton to purchase a stamping machine for $1,000. The machine cannot be used on regular motors and will have no resale (scrap) value after the order is filled. When a transfer creates differential fixed costs, the Transfer Pricing Matrix can be modified to present the transfer's differential profit for both the surplus and full capacity situations, as shown in Exhibit 21-10.

Note that the calculation format is based upon the contribution margin approach for profit calculations pre-sented in Chapters 18, 19, and 20. Now, assume that the $275 external purchase price includes the special name plate. First, the differential CMU per motor is computed. Then, it is multiplied by sales volume to obtain contribution margin. Finally, fixed costs are subtracted from contribution margin to arrive at net profit. When Braxton has sufficient surplus capacity to fill the order, Yard Equipment Company will be $1000 better off if the 20 motors are transferred. When Braxton does not have surplus capacity to fill Clip-per's demand, but a transfer occurs anyway, Yard Equipment Company will be $1,200 worse off than if Clipper were to purchase motors externally at $275 each.

Exhibit 21 -8 The Transfer Pricing Matrix

Range of transfer prices Transferred product made with selling division surplus capacity: (Exhibit 21-6

Transferred product taken from normal sales:

full capacity situation: (Exhibit 21-6)CEILING: (determined by the “buy-ing” division: Clipper)

External purchase price:$275.00


FLOOR: (determined by the

“selling” division: Braxton)

Internal variable cost:$175.00

External sales price less variable costs saved by transferring:

$285.00Transfer's differential contribution margin per motor: (for the “com-pany”: Yard Equipment)

Ceiling - Floor:$100.00

Ceiling - Floor:<$10.00>

Exhibit 21 -9 The Transfer's Differential Profit When There Is Insufficient Capacity Available in the Selling Division

Range of transfer prices: Transferred product make with selling division surplus capacity: (Exhibit 21-6)

Transferred product taken from normal customer sales: Full capacity situation (Exhibit 21-7)

CEILING: (determined by the “buy-ing” division: Clipper)



FLOOR: (determined by the “selling” division: Braxton)



$285.00Transfer's differential contribution mar-gin per motor: (for the “company”: Yard Equipment)



Motors transferred from: (multiply by contribution margin per motor)

x 50 motors x 25 motors

Total contribution margin from surplus or full capacity:

$5,000.00 <$250.00>

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Consider the surplus capacity situation column in Exhibit 21-10. What is the minimum number of motors that can be transferred before Yard Equipment Company incurs a loss from transferring? In other words, at what volume will Yard Equipment Company be indifferent between transferring versus buying motors from an external supplier? This is the volume where there is no differential profit; that is, the break-even point. The break-even formula is:

Differential fixed costs of $1,000 / CM per motor of $100/motor = 10 motors

IMPUTING THE CEILING WHEN NO EXTERNAL SUPPLIER EXISTS. The Transfer Pricing Matrix approach also works even when there is no external supplier for the transferred motors. In this case, the ceiling price is imputed using basic cost-volume-profit techniques presented in Chapters 18 and 19.

This example assumes that Clipper has received a special order for lawn mowers from the city's Parks and Recreation Department. These lawn mowers will be used to mow the baseball fields for the Little League teams and the city softball leagues. The city can only afford to pay $400 each for the lawn mowers. Refer-ring back to Exhibit 21-5, the normal lawn mower sales price is $600. The Clipper manager wants to accept this order because he feels a civic obligation and his division currently has enough surplus capacity to produce the lawn mowers without giving up any normal sales.

However, Braxton is the only available source for the motors. Because there are no other suppliers, there is no ceiling price (which was $275) available for the transfer's differential profit analysis. All other infor-mation is the same as used in Exhibit 21-5.

As this is a special sales order for Clipper, the lawn mower sales price could go as low as the incremental costs of making and delivering the special-order lawn mowers. Using the Exhibit 21-5 information, the Clipper manager performs the following analysis

From the Clipper manager's viewpoint, motors could cost up to $260 each. If so, then the CMU on this order would be $0, and there would be no differential profit or loss for Clipper from the sale of these mow-ers to the city. If the price of a motor is less than $260, Clipper will realize a positive CMU. Thus, the Clipper manager can spend up to $260 for a motor (a maximum transfer price), if he is willing to make no profit on the order. The $260 becomes the ceiling transfer price for the Transfer Pricing Matrix. Exhibit 21-11 shows how the ceiling price row is modified to present this situation.

If Braxton has the surplus capacity to produce the motors needed by Clipper for this special order, and the motors are transferred, then Yard Equipment Company is $85 per lawn mower better off. If Braxton does not have any excess capacity available to make motors, then this order would result in a $25 loss per lawn mower to Yard Equipment Company.

Exhibit 21 -10 The Transfer's Differential Profit with Differential Fixed Costs

Range of transfer prices: Transferred product make with selling division surplus capacity: (Exhibit 21-6)

Transferred product taken from normal customer sales: Full capacity situation (Exhibit 21-7)

CEILING: (determined bythe “buying” division: Clipper)



FLOOR: (determined by the “selling” division: Braxton)


External sales price less variable costs saved by transferring

:$285.00Transfer's differential contribution margin per motor: (for the “company”: Yard Equipment)



Motors transferred from: (multiply by contribution margin per motor)

x 20 motors x 20 motors

Contribution margin from surplus or full capacity situation:

$2,000.00 <$200.00>

Less differential fixed costs <1,000.00> <1,000.00>Net profit from transfer: (pre-tax) $1,000.00 <$1,200.00>

Special-order sales price $400Less other variable costs of making lawn mowers in Clipper Division <140>CMU per special lawn mower before the cost of a motor from Braxton $260


CALCULATING A TRANSFER'S DIFFERENTIAL PROFIT: CONCLUDING REMARKS. By using the Transfer Pricing Matrix format presented in Exhibit 21-8, the Braxton and Clipper managers can determine whether to transfer in any optional transfer situation they may encounter. This format can be used to calculate the transfer's differential profitability in the following situations:

• When Braxton has sufficient surplus capacity for the transfer and when it has no surplus capacity avail-able (Exhibit 21-8)

• When Braxton has only limited capacity (not enough) available (Exhibit 21-9)• When the transfer creates differential fixed costs (Exhibit 21-10) • When there is no other supplier of the intermediate product (Exhibit 21-11)

The two profit center managers should agree to transfer whenever Yard Equipment Company will realize an increase in overall corporate profits from transferring. If Yard Equipment Company has created these divisions as real profit centers, however, the two managers must make a joint decision about transferring. Why would the two managers, knowing that they should transfer, not agree to do so? The reason is that, with certain types of reward systems, they may also have to mutually agree on a transfer price, which they may not be able to do. The rest of this chapter considers the role of the transfer price in optional transfer situations between profit centers.

SETTING THE TRANSFER PRICETo record the transfer within the accounting system, a transfer price is needed. Three questions must be answered:

1. What are the options?2. What is the effect of each option on the divisional segment margins of Clipper and Braxton?3. Who should set the transfer price?

TRANSFER PRICE OPTIONS AND THEIR EFFECTS ON DIVISIONAL SEGMENT MARGINS. The transfer price affects the SMs reported by each division, because the transfer price is the sales price for transferred motors in the Braxton Division and the cost of motors in the Clipper Division. If the transfer price increases, Braxton Division's CMU, CM, and SM will go up. At the same time, though, the cost of motors to Clipper Division will also go up, and its CMU, CM, and SM will go down. This can be important to the two managers if they are rewarded for maximizing their individual division SMs. In this situation, the Braxton manager will want the highest transfer price possible, but the Clipper manager will want the lowest transfer price possible. To illustrate, ti-C, e transfer prices will be analyzed.

• Using the ceiling price. Refer back to Exhibit 21-8. Consider setting the transfer price at the ceiling of the transfer price range in the first column. This is the external purchase price of a motor ($275). Clipper then can buy a motor externally for $275 or internally for $275. If the cost of a motor is the same, the Clipper manager will be indifferent between buying externally or transferring because he will not save any money from either option.

If the transfer price is $275, though, the Braxton manager will realize a $100 CMU from transferring. She will sell the motors to Clipper for $275 and incur $175 in variable costs, resulting in the $100 CMU.

• Using the floor price. Now consider setting the transfer price at the floor, which is $175 if Braxton has

Exhibit 21 -11 The Transfer's Differential Profit When There is No Other Supplier for the Intermediate Product

Range of transfer prices Transferred product Trade with sell-ing division surplus Capacity:

(Exhibit 21-6)

Transferred product taken from normal Customer sales:

Full capacity situation (Exhibit 21-7)

CEILING: (determined by the “buying” division: Clipper)

Imputed:$260.00

Imputed:$260.00

FLOOR: (determined by the “sell-ing” division: Braxton)



$285.00Transfer's differential contribution margin per motor: (for the “com-pany”: Yard Equipment)



CHAPTER 21


sufficient surplus capacity for the order or $285 if no surplus capacity is available. In this case, Braxton will not show any change in CMU from transferring. With surplus capacity, both the internal sales price (transfer price) and the variable costs are $175, yielding no contribution margin per motor. With no sur-plus capacity, whether Braxton sells externally at $300 per motor or internally at $285, the CMU will be the same.

What happens to Clipper's segment margin, though, if the transfer price is set at the floor? Currently, Clip-per can buy motors externally for $275 each. If it can get them from Braxton for $175, it will save $100, and the CMU per lawn mower will go up $100. If the floor price of $285 is used because Braxton has no surplus capacity available, then Clipper will see its CMU go down $10 because the cost of a motor has increased $10 (from $275 to $285).

• Using the midpoint of the transfer price range. In the Surplus Capacity column of Exhibit 21-8, the transfer price range is $175 to $275. The midpoint of this range is halfway between these two endpoints; that is, at $225. In the Full Capacity column, halfway between the two endpoints ($275 and $285) is $280.

What happens to both divisions' CMUs if the transfer price is set at the midpoint of the range ($225 with surplus capacity, $280 at full capacity)? In the surplus capacity situation, Braxton will realize a differential CMU of $50 per motor ($225 sales price - $175 cost), and Clipper will also realize a $50 differential CMU per lawn mower ($225 motor cost instead of $275).

In the full capacity situation, each division will report a $5 per motor loss on the transfer. For Clipper, the transfer price will be $280, which is $5 per motor more than the current external purchase price of $275. If the cost of a motor goes up $5, the CMU on a lawn mower goes down $5. For Braxton, the transfer price would be $280, which will only yield a CMU of $105 ($280 - $175). This is $5 less than the current CMU Braxton can make on each of these motors by selling them to normal customers.

What do these examples indicate?

• If the transfer price is set at the ceiling of the range, all of the transfer's differential profit appears in the selling division's (Braxton's) income statement.

• If the transfer price is set at the floor, all of the transfer's differential profit appears in the buying divi-sion's (Clipper's) income statement.

• If the transfer price is set at the midpoint of the range, then the divisions share the transfer's differential profit (or loss) equally.

• Also notice that for each transfer price option, the differential CMUs reported by the two divisions will always sum to the transfer's differential profit.

This leads to two conclusions.

First, the transfer's differential profit for Yard Equipment Company is independent of the transfer price finally set (the transfer price cannot influence the differential profitability to the overall corporation),8

This conclusion may seem rather surprising, since a sales price usually determines profit. This is true in two-party sales transactions, but even though a transfer price is the internal sales price for an intermediate product, the transfer situation is a three-party sales transaction. In addition to the buying and selling divi-sions, the corporation that owns both of them is a stakeholder. Their decision should be based upon whether the transfer creates a differential profit which will increase overall corporate profits. Their joint decision should not be based on how much they may be able to increase their segment margins through the use of a particular transfer price.

Secondly, the transfer price is only a profit-sharing rule between the two transferring divisions.

As with any sales price, a profit results for the seller (Braxton). The profit can be positive or negative. Consider the surplus capacity situation in Exhibit 21-8 again. If the transfer price is set at the floor, Brax-ton's CMU is zero. If it is set at the ceiling, Braxton's CMU equals the entire differential profit realized from the transfer, which is $100. Setting the transfer price at the midpoint, Braxton's CMU is $50, half of the total.

For Clipper (the “buyer”), the price paid for motors is a cost of making lawn mowers. If the transfer price is set at the ceiling, Clipper's cost for a motor is the same $275 whether the motor is purchased from Brax-

8. In certain situations (especially with multinational corporations), a transfer price can create differential tax effects. Tax and tariff implications usually are not covered at this level, however. The conclusion is still valid, though, if differential taxes and tariffs are added into the variable costs of transferring.


ton (transferred) or purchased from an external supplier. Setting the transfer price at the floor of $175, Clipper saves $100 on the cost of a motor if it is transferred. This savings is all of the transfer's differential profit. If the transfer price is set at the midpoint of the range, Clipper's cost savings on a motor equals $50 (current motor cost of $275 versus the transfer at $225), which is half of the total. The point to remember is that the transfer price affects the CMU, CM, and SM of each division, but it does not affect the differential profit that the corporation realizes from the transfer.

WHO SHOULD SET THE TRANSFER PRICE? This depends upon how Yard Equipment Company rewards the two managers for making the right decision. Four reward policies are possible, only one of which does not depend upon the transfer's differential profit:

• Reward system not based on the transfer's differential profit. With this reward system, Yard Equipment Company either does not specially reward the managers for making the correct decision, or it gives them a set amount (a bonus) that is not based on the differential profits created by the transfer. The logic behind not specially rewarding the managers is that they should make good decisions because doing so is part of their job. Managers should not receive a special reward for just doing their jobs.

Yard Equipment management may decide, however, that each manager should get a bonus of $1,000 (or some other amount). The managers will not care how much of the transfer's differential profit appears in their income statements because it will not affect their rewards. Thus, the transfer price is not important to them. In this case, the accountant can preset the transfer price for all transfers to satisfy other needs of the accounting system, such as the need to minimize interdivisional profit elimination journal entries in pre-paring consolidated financial statements for the company (a topic for Advanced Financial Accounting) or the need to trace cost variances to the proper RCs for performance evaluation.

In this example, Braxton is a profit center primarily selling motors to external customers, so all fixed man-ufacturing overhead should be “absorbed” (paid for) by externally sold motors. Both Braxton and Yard Equipment Company realize this. They would not be selling motors externally if they did not believe all fixed costs could be recovered and a satisfactory profit made. In other words, because Braxton is a profit center, and Yard Equipment Company has not required a long-term commitment to transfer motors to Clip-per, all of Braxton's fixed costs should be recovered by normal external sales. Thus, the Braxton manager views the transfer decision as a special-order pricing problem, in which she calculates a minimally accept-able internal sales price (the floor in Exhibit 21-5).

Assume 100 motors were sold to external customers and 20 motors were transferred to Clipper. Using the floor as the transfer price results in the segmented contribution margin-based income statement illustrated in Exhibit 21-12 (based on the information presented in Exhibit 21-5). Transferring at the floor price allows Yard Equipment Company to see Braxton's real SM made by external sales and transfers. The Brax-ton manager just broke even on external sales. She should have made a $2,000 SM, but she had $2,000 in unfavorable production cost variances. She also lost another $200 on the 20 motors transferred because of the $10 per motor unfavorable variable production cost variances.

If the ceiling price had been used to transfer motors, this information would be much less clear. Transfer-ring 20 motors at $275 each would result in an extra $2,000 in contribution margin and segment margin reported for transfers ($100 per motor from Exhibit 21-8 for each of the 20 motors transferred). Braxton really lost $200, but the accounting report would now show an SM on transfers of $1,800! Thus, using the floor price for transfers will better satisfy management's need for performance evaluation information. Using the floor price should also provide a greater motivation for the Braxton manager to control her costs because cost overruns will not be “buried” in the SM reported on the transferred motors.

• Reward systems based on a transfer's differential profit. Yard Equipment Company can choose among three reward system alternatives within this option. The first reward system involves directly rewarding each manager for the transfer decision. This can take one of two forms. If Yard Equipment management predetermines the relative share of a transfer's differential profit each manager should receive, then the transfer price can be preset. For example, assume each manager will receive a bonus based on half of the transfer's differential profit. Then, the transfer price can be set at the midpoint of the range shown in Exhibit 21-8.

To illustrate, assume Braxton has sufficient surplus capacity. By setting the transfer price at $225, each manager will show a $50 greater CMU, half of the total for Yard Equipment Company. Since the Braxton manager incurred cost variances of $10 per motor, her reported CMU from the transfer will be only $40 per motor. The $10 cost overrun reduced the transfer's $100 anticipated differential profit to only $90. The accounting system should report this within the Braxton income statement because the $10 cost variance

CHAPTER 21


was her responsibility and should affect her rewards, not the Clipper manager's. The Braxton income statement is shown in Exhibit 21-13.

With the second reward system in this category, the relative share of each manager's direct reward from transferring may not be predetermined. In this type of reward system, Yard Equipment management wants the two managers to decide how to share the transfer's differential profit and reward. This means that the two managers will have to agree to a transfer price. The managers, through mutually setting the transfer

Exhibit 21 -12 Segmented Income Statement for Braxton Motors: Transfer Price at Floor of Transfer Pricing Matrix Range

EXTERNAL SALESBudgeted Actual

Units Per Unit Totals Per Unit TotalsSalesExternal 100 $300 $30,000 $300 $30,000Transfers 20Total salesVariable Costs:Production 120a 100 10,000 110 11,000Other: External 100 90 9,000 90 9,000Other: Transfers 20Total variable costs <$190> <$19,000> <$200> <$20,000>Contribution Margin $110 $11,000 $100 $l0,000Fixed Costs:Production 8,000 9,000Other 1,000 1,000Total fixed costs <$9,000> <$10,000>Segment margin $2,000 $-0-

a.Of the 120 units produced, 100 were for external sales ($10,000 @ $100 each), and 20 units were for transfers($2,000 @ $100 each).

Exhibit 12B TRANSFERS BRAXTON MOTORS TOTALS

Cost VariancesPer Unit

Totals Per Unit

Totals Actual Per Unit Totals

SalesExternal $30,000 $ 0 $ 0Transfers $175 $ 500 $175 $3,500 3,500Total sales $33,500 $ 0 $ 0Variable Costs:Production 100 2,000 110 2,200 13,200 <10> <1,200>Other: External 9,000 0 0Other: Transfers 75 1,500 75 1,500 1,500 0 0Total variable costs <175> <3,500> $ 185 <3,700 <23,700> <$10> $1,200>-Contribution Margin $ 0 $ 0 <$10> <$200> $9,800 <$l0> <$1,200>Fixed Costs:Production 9,000 <1,000>Other <$1,000> 0Total fixed costs <10,000> <1,000>Segment Margin $-0- <$200> <$200> <$22>a <$2,200>

a.The segment margin cost variance total for Braxton is averaged over the motors sold externally only.


price, will negotiate how much of the transfer's differential profit each will report in his or her income statement.9

The third reward system is probably the most common way corporations reward profit centers. The man-agers' rewards are based on an aggregate divisional segment margin that includes both transfers and exter-nal sales. In this situation, the profit center manager who reports the highest segment margin gets the

Exhibit 21 -13 Segmented Income Statement for Braxton Motors: Transfer Price at Midpoint of Transfer Pricing Matrix Range

EXTERNAL SALESBudgeted Actual

Units Per Unit Totals Per Unit TotalsSalesExternal 100 $300 $30,000 $300 $30,000Transfers 20Total salesVariable Costs:Production 120a 100 10,000 110 11,000Other: External 100 90 9,000 90 9,000Other: Transfers 20Total variable costs <$190> <$19,000> <$200> <$20,000>Contribution Margin $110 $11,000 $100 $l0,000Fixed Costs:Production 8,000 9,000Other 1,000 1,000Total fixed costs <$9,000> <.$10.000>Segment margin $2,000 $-0-

a.The segment margin cost variance total for Braxton is averaged over the motors sold.

Exhibit 12-13B TRANSFERS BRAXTON MOTORS TOTALS Cost Variances

Per Unit

Totals Per Unit Totals Actual Per Unit

Totals

SalesExternal $30,000 $ 0 $ 0Transfers $225 $4,500 $225 $4,500 4,500Total sales $34,500 $ 0 $ 0Variable Costs:Production 100 2,000 110 2,200 13,200 <10> <1,200>Other: External 9,000 0 0Other: Transfers 75 1,500 75 1,500 1,500 0 0Total variable costs <175> <3,500> <$ 185> <3,700 <23,700> <$10> $1,200>-Contribution Margin $ 0 $ 0 <$10> <$200> $9,800 <$l0> <$1,200>Fixed Costs:Production 9,000 <1,000>Other <$1,000> 0Total fixed costs <10,000> <1,000>Segment Margin $1,000 $800 $800 <$22> <$2,200>

9. Reasons why Yard Equipment Company might want to use this and the next reward system are discussed in the last section of the chapter.

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largest reward. As in the previous alternative, the two managers must negotiate a transfer price. Eachmanager, in attempting to maximize his or her segment margin, seeks to capture as much of the transfer'sdifferential profit as possible. Thus, the Braxton manager negotiates for the highest transfer price possi-ble, while the Clipper manager seeks the lowest transfer price he can get.

The pros and cons of requiring negotiation will be discussed in the next section, which also discussestransfer pricing policies actually in use. Exhibit 21-14 summarizes the reward systems and the recom-mended transfer pricing policies.

NEGOTIATION: “THE GOOD, THE BAD, AND THE UGLY”. If Yard Equipment Company useseither of the last two reward systems, the managers are placed in conflict with each other, which can leadto suboptimal decisions. This goal-congruence problem results if they choose not to transfer when theyshould simply because they cannot agree on a transfer price.

Why would the managers ever not decide to transfer when it would increase Yard Equipment Company'soverall corporate profit? One reason is that they may not know the relevant costs for each profit centerand therefore do not know that transferring is the correct decision. This is a failure of the managementaccounting system. Many existing systems have been primarily designed for financial accounting needs,not for management's decision-making needs, thus this is a pervasive problem with traditional accountingsystems.

In other cases, the profit center managers know the relevant costs for their own profit center but do notshare that information with each other or with Yard Equipment headquarters. Why would they not sharerelevant information? Consider the Braxton manager's situation (Exhibits 21-5 and 21-8). If she has suffi-cient surplus capacity for the transfer, her floor price should be $175. However, she may be tempted toclaim that her cost of a motor is $190 (the standard variable cost for external sales). By increasing thefloor price, the range of transfer prices appears to be $190 to $275. The differential profit from transfer-ring would then appear to be $85 instead of the real $100. If the managers share the $85 equally, theywould agree to a $232.50 transfer price (the midpoint of the $190 to $275 range). In reality, the Braxtonmanager would get more of the transfer's differential profit, and thus a greater reward, than the Clippermanager. In this scenario, she would get one half of the transfer's apparent differential profit ($42.50),plus the $15.00 by which she overstated her cost. Her cost should have been $175, not $190. If she doesnot incur any cost variances, her share of the transfer's differential profit will be $57.50 per motor ($42.50+ $15.00, or $232.50 transfer price - $175.00 real cost). Meanwhile the Clipper manager receives only$42.50 of the transfer's differential profit.10

Obviously, if the Braxton manager could argue that her floor was even more than $190, she could obtain even more of the transfer's differential profit for herself. There are a number of motor “costs” she might use that are greater than her real relevant cost: the $180 standard absorptive manufacturing cost (Exhibit 21-2b), or the $280 budgeted average cost of externally sold motors ($190 variable cost + $90 allocation of total fixed costs from Exhibit 21-13). She might even claim that since she sells motors for $300 each, that is the minimum price she will accept from Clipper (or $275 allowing for the variable costs saved from an internal sale), hiding the fact that she has surplus capacity.

Exhibit 21 -14 Reward Systems and Transfer Pricing Policies

Reward system option Transfer price•Rewards not based on transfers' differential profit Preset at floor

•Rewards based on differential profit created by transfers1. Direct reward for transferring:a. Predetermined percentage Preset transfer price using profit sharing percentageb. No predetermined percentage None preset; managers must negotiate

2. Indirect reward based on aggregate divisional segment margins None preset; managers must negotiate

10. Remember that the transfer price is only a profit-sharing rule between the two managers. The CMU reported by each manager, based on the transfer price used, must always sum to the company total shown on the bottom line of the Transfer Pricing Matrix in Exhibit 21-8. In this case, Clipper would report a $42.50 per motor CMU and Braxton would report a $57.50 CMU. The sum is the tranferor’s $100.00 per motor differential profit for Yard Equipment Company.


Product costs can be calculated in different ways to serve different purposes. It is often difficult to identify which costs are relevant to a particular decision situation faced by management. Withholding the relevant information from the rest of the “corporate family” and/or using the wrong information creates complex and serious ethical problems for the management accountant. The Institute of Management Accountants' Statement of Management Accounting #1C. Standards of Ethical Conduct for Management Accountants sections on competence, integrity, and objectivity may be violated if the Braxton Division's controller does not provide the correct information. There is no easy way to resolve the management accountant's conflict between professional competence and ethics on the one hand and the wishes of the Braxton manager on the other.

Some companies require corporate intervention (arbitration) to set the transfer price when the two manag-ers cannot compromise on how to share the transfer's differential profit. Both arbitration and negotiation are time-consuming activities for all the management personnel involved, though. Another problem with negotiation is that divisional SMs become sensitive to the negotiating skills of the managers. But this prob-lem is not unique to transfer pricing decisions. In many actual situations, profits are in part determined by the negotiating skills of profit center managers, regardless of whether the negotiations involve an internal or external sale.

Considering all the potential problems with negotiation, why would Yard Equipment Company use reward systems that require it? One reason is that the ability to negotiate successfully is a desirable profit center managerial skill. Requiring managers to negotiate mimics the external sales decision processes in which they primarily engage. One of the benefits from decentralizing is the managerial training ground provided by RCs.

A second reason is related to the purpose of decentralizing into profit centers in the first place. In some sit-uations, corporate headquarters does not have the information needed for certain decisions; it only exists at the profit center level. Thus, decentralizing (allowing the divisional manager to act without prior consent from headquarters) results in better and quicker decisions. This reason is not valid for transfer decisions, though. Negotiation does not produce quicker decisions. Further, when negotiation is required because of the reward system used, then there is an increased likelihood for dysfunctional decisions. Finally, this rea-son will disappear as decentralized enterprises implement client/server, interoperable ICBISs (see Chapter 20). Information sharing will replace private, local RC information.

Information sharing through interoperable ICBISs presents some interesting implications for the negotia-tion process. For example, the Clipper Division manager can purchase motors for $275 from a competitor of the Braxton Division. Braxton motors normally sell for $300. During negotiations, the Braxton manager may not be willing to accept a transfer price below $285 (the full capacity floor price of the Transfer Pric-ing Matrix in Exhibit 21-8) even if she has sufficient surplus capacity available.

Why would she not consider accepting a lower transfer price (down to the $175 surplus capacity floor price)? There are at least two possible explanations. First, the Braxton manager may believe that her com-petitor is offering an artificially low price to fill up his factory. If that competitor finds enough marginal business elsewhere, then this $275 external purchase cost may not be valid. Thus, the Braxton manager may be motivated to hold out for her normal CMU through a $285 transfer price. The second possible explanation for holding out for a $285 transfer price is that the manager believes that she can fill the Brax-ton factory to full capacity with other sales. If so, then she may not be motivated to accept a transfer price that will result in less CMU.11

Upper management wants the two managers to make the decision themselves because the relevant infor-mation exists on the divisional levels, and these managers are in the best position to evaluate their markets and set marketing strategies. Decentralization works best when information is at the local level and divi-sions are independent from each other. Requiring transfers may not be congruent with the corporation's reasons for creating the decentralized divisions.

As firms move toward becoming world-class manufacturers, however, the relevant transfer information should be as readily available to all parties as it is at the divisional level. New information technologies and networked, client/ server interoperable ICBISs may overcome the need for decentralized decision making, at least for these types of transfer decisions.

11. See Rene Manes, “Birch Paper Company Revisited: An Exercise in Transfer Pricing,” Accounting Review, July 1970, pp. 565-572; and Robert Swieringa and John Waterhouse, “Organizational Views of Transfer Pricing,” Accounting, Orga-nizations and Society, 1982, pp. 149-165.

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With reward systems that require negotiation, the transfer decision becomes a two-stage process. First, the managers must decide whether to transfer, and then they have to agree on a profit-sharing transfer price. The decision to transfer should be based on whether the transfer creates a differential profit for Yard Equipment Company. Because the transfer price has nothing to do with whether Yard Equipment realizes a differential profit on the transfer, it should be irrelevant to the managers when making their joint deci-sion to transfer. it becomes relevant to the two managers, however, when the amount of their individual rewards depends upon the transfer price. Thus, they do not consider the decision to transfer as a separate, first decision in a two-stage process. Instead, whether the transfer will occur depends on whether they can agree on a transfer price. Whenever divisional managers place their personal rewards and goals ahead of the corporation's, the possibility for suboptimal decisions exists. Upper management may have to deal with this goal-congruence problem if it chooses a reward system requiring negotiation.

Negotiating a transfer price, as a requirement for the decision to transfer, is incongruent with the firm's goal of transferring when corporate profitability can be increased (because the managers may choose not to transfer if they are unable to agree on a price). The two reward systems that require negotiation can only be justified by the belief that the marginal utility of other organizational goals (satisfied by requiring the negotiation process) is greater than the expected marginal utility from the transfer's differential profit pos-sibly lost.12

This leads to the last transfer pricing policy found in practice. Many companies allow the profit center managers to decide whether to transfer, but dictate the use of a certain transfer price. Often the required transfer price is the external sales price, for example $300 for the motor (Exhibit 21-5). This market price-based policy is often justified because it is objective and simplifies the decision process. Of course, the Clipper manager may have little incentive to transfer if he will incur a higher cost.

Even if the transfer price were reduced to the ceiling of the range in Exhibit 21-8, the Clipper manager would not share in any of the transfer's differential profits created for Yard Equipment Company. Setting the transfer price at the ceiling results in all the transfer's differential profit being reported in Braxton's income statement. Why might the Clipper manager agree to a transfer when the ceiling price must be used? By using an internal supplier (Braxton versus an external supplier), he may obtain better control over motor quality and more reliable delivery schedules.

In summary, with the advent of multinational, world-class enterprises, optional transfers between decen-tralized profit centers are presenting the modern management accountant with many challenges. Design-ing a high-quality profit management system will require many knowledge areas, such as:

• Use of activity-based costing and management techniques to more accurately measure the costs of inter-mediate products.

• An understanding of the relevant profit elements that will influence these profit planning decisions.• An understanding of the international arenas including cultural, political, and regulatory environments in

which the divisions must operate.• The ability to design client/server interoperable ICBISs so that the relevant information can be shared

between decentralized divisions.• The ability to design information displays and reports, in usable and simple formats, so that the managers

can effectively and efficiently make goal congruent decisions.• Knowledge of the reward systems in use and their effects on the transfer decision.• And a keen sense of ethical conduct, especially in transfer situations that require negotiation.

There is little doubt that the setting of transfer pricing policies will continue to be one of the most contro-versial topics in modern profit management systems design.

SUMMARY OF LEARNING OBJECTIVESThe major goals of this chapter were to enable you to achieve three learning objectives:

Learning objective 1. Distinguish between components made in cost centers and intermediate products made in profit centers.

12. Marginal utility is the incremental benefit or worth of something. Here the argument is that the benefits in terms of better managerial skills from requiring negotiation are more important to Yard Equipment Company's upper management than the profits that might be lost if a transfer does not occur when it should.


Components made in cost centers are used by other RCs in making their products. Cost center managers do not sell components to external customers. Instead, they are required to transfer the components to other RCs that need them. An RC that sells to outside customers receives sales revenues and contributes a profit to the overall corporation. In that case, the RC is a profit center. A profit center's product that can be sold externally or used by another RC in its production is called an intermediate product.

As this chapter has shown, determining a transfer pricing policy for profit centers making and selling inter-mediate products is more difficult than for cost centers that only make components for use in other RCs. Different organizational and accounting system goals are involved with intermediate profit center products than with cost center components. Thus, as the first step in understanding transfer pricing policies, cost centers making components must be distinguished from profit centers that make intermediate products.

Learning objective 2. Understand the management accounting system's goals for transfer costing and transfer pricing.The distinction between components transferred from cost centers and intermediate products transferred from profit centers also applies to transfer costing and transfer pricing. Transfer costing policies are for cost centers, which are required to transfer components to other RCs. Transfer pricing policies are for profit centers transferring intermediate products at their option.

A company wants cost center managers to meet their production schedules, and deliver quality compo-nents on time when needed. They should also control their costs; that is, not incur unfavorable cost vari-ances. The accounting system should report information that allows management to determine whether the cost center manager incurred cost variances associated with a transfer. By doing this, the accounting sys-tem should assist the organization in motivating the cost center manager to control costs (an organizational goal-congruence objective).

The company wants profit center managers to sell products profitably. This involves, in part, choosing the most profitable customers and controlling costs so that budgeted profits are realized. The accounting sys-tem's role is to provide information that will help the profit center manager select the most profitable cus-tomer and assist in determining whether costs were controlled.

With respect to transfer pricing, a high-quality profit management system will report the relevant informa-tion needed to make the transfer decision. A Transfer Pricing Matrix display satisfies this goal. The system should also report profit variances associated with the transfer. This requires segmenting the selling divi-sion's income statement into external sales and transfers.

Learning objective 3. Determine how the different cost and price options can affect managerial decision making, planning, cost management, and performance evalua-tion.Transfer costs can be the actual production cost, the standard production cost, or a market price of the com-ponent. The cost can be the variable cost or the absorption cost. The chapter argued that the transfer cost-ing policy should use standard absorptive manufacturing cost. This option provides the most meaningful information for management to use in determining whether cost variances occurred within the cost center. It also helps motivate the cost center manager to control costs. Using actual cost allows cost variances to be passed on to the RC receiving the component, reducing the motivation of the cost center manager to control costs. Using a market price makes it harder for management to identify cost variances within a cost center and creates pseudo profits that complicate the accounting system and performance evaluation.

In setting a transfer pricing policy, a number of possible transfer prices can be used. The correct transfer price depends upon the reward system used by upper management. First, though, the two profit center managers need to determine whether a transfer is profitable. When the selling division has surplus capac-ity, this involves comparing the cost of making the intermediate product against the cost of buying it from another supplier. When the supplying division is already producing at full capacity for normal customers, the comparison changes to consider the contribution margin per motor that the profit center is currently making. This process determines the minimum acceptable transfer price, which is compared with the cost of buying the intermediate product from an outside supplier (the maximum acceptable transfer price).

The calculation of a transfer's differential profitability can he further complicated if the transfer creates fixed costs, it there is insufficient capacity available in the supplying division, or if no other sources for the intermediate product exist. In all these situations, though, a Transfer Pricing Matrix can be created to cal-culate the transfer's differential profit for the company as a whole. The differential profit will always be the difference between the ceiling and floor of the range of transfer prices (Exhibit 21-8). When the ceiling is

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greater than the floor, the transfer creates differential profits, and the possible transfer prices that are acceptable to both managers are limited to those within the range.

With some reward systems, the transfer price can be preset. With others, it must be negotiated by the two profit center managers. The chapter recommended that the transfer price be preset at the floor price when the managers receive no special rewards for transferring. The selling division's income statement should be segmented between external sales and internal sales to promote cost control and identify cost variances within the RCs responsible.

If the managers receive a predetermined amount of a reward for making correct transfer decisions, the transfer price can be preset to allow for the proper profit-sharing ratios. This procedure stems from the realization that the transfer price only determines how much of the transfer's differential profit will be reported within each profit center's income statement.

if the managers must decide how much of a reward each will receive, they will have to negotiate the trans-fer price. Negotiation has its good, bad, and ugly points. The company will have to evaluate the trade-offs between using different reward systems and requiring negotiation. Regardless of the choice, the manage-ment accountant should be able to develop a transfer pricing policy to match the reward system. The vari-ous policies discussed in this chapter were summarized in Exhibit 21-14 and are presented as a flowchart in Exhibit 21-15.

Exhibit 21 -15 Transfer Policy Flowchart

Transfer Policies:

1. Use Standard Absorptive Manufacturing Cost. Report Selling Division cost variances.

2. Same as 1 with transfers reported as deduction from COGS.

3. Preset at Floor. Segment Selling Division into external versus internal sales. Report cost variances for both profit centers.

4. Preset to yield percentages of shared profits. Segment Selling Division into external versus internal sales. Report cost variances for both profit centers.

5. Managers negotiate transfer price. Segment Selling Division into external versus internal sales. Report cost variances for both profit cen-ters.

TPPolicy 1 Policy 2

Policy 3 Policy 4 Policy 5

YES

NO

cost centre profit centre

TP

TP TP TP TPPolicy 6

YES

NO

RC type?transferprofitable?

rewardtransfers

do nottransfer

no specialrewards

directpredeterminedamount

no directpredeterminedamount

indirect rewardthru segmentmargin

transferrequired?


IMPORTANT TERMSCeiling transfer price The lowest purchase price offered by an external supplier to a responsibility center

that needs an intermediate product. This is the highest transfer price that the responsibility center manager will accept. Thus, it is the ceiling of the range of transfer prices in the Transfer Pricing Matrix.

Components Parts that are produced within cost centers and are required to be transferred to other respon-sibility centers.

Floor transfer price The lowest transfer price acceptable to the responsibility center supplying an inter-mediate product. It usually can be calculated by summing the internal variable cost to produce and deliver the intermediate product, the contribution margin per unit lost from normal sales that would have to be given up in a transfer, and the unitized differential fixed costs involved in the transfer.

Intermediate products Products that can be sold to external customers or transferred to other responsibil-ity centers as direct materials in that center's product.

Range of transfer prices The set of mutually acceptable transfer prices for optional transfers between profit centers. It is bounded by the ceiling and floor transfer price options. The difference between these endpoints of the range determines the differential profitability from the transfer. This range also represents the set of possible transfer prices that both profit center managers could agree to.

Transfer The process of moving a component or intermediate product from one responsibility center to another within a company. Stated another way, it is the exchange of goods or services between production responsibility centers of the same enterprise.

Transfer cost The cost used in the accounting system to record required transfers of component parts from cost centers.

Transfer price The price used in the accounting system to record optional transfers of intermediate prod-ucts from profit centers.

Transfer Pricing Matrix A presentation format for the relevant accounting information involved in an optional intermediate product transfer between profit centers. It can be used to calculate the trans-fer's differential profitability and to present the range of mutually acceptable transfer prices to both managers.

DEMONSTRATION PROBLEMSDEMONSTRATION PROBLEM 1 The Transfer Pricing Matrix and optional profit center transfers.

Nessle Chocolate Corporation owns two profit center subsidiaries: Chocolate Bar Company and Nut Faun. Transfers are not required between subsidiaries because of Nessle's commitment to decentralization. Each profit center is evaluated based on its profit variances and rewarded for obtaining its target profit. Choco-late Bar Company normally buys nuts for its chocolate nut bar from a competitor of the Nut Farm. The fol-lowing information about the two divisions is available:

Required:

a. Prepare a Transfer Pricing Matrix for the managers so that they will have the relevant information for this transfer decision.

NUT FARM DIVISIONProduction data:Current volume: 1,000 bushels sold to external customersCapacity: 1,500 bushels could be produced in a monthCost data:Normal variable costs: Standard Costs

Per Unit TotalsProduction costs $10.00 $10,000Other costs 9.00 9,000Totals $19.00 $19,000

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b. Should the managers agree to transfer?c. If the ceiling of the range of transfer prices is used as the transfer price, how much of the differential

profits created will appear in each profit center's net income?d. Answer Requirement (c) if the floor is used.e. Answer Requirement (c) if the midpoint of the range is used.f. How will the use of each of the transfer price options in Requirements (c), (d), and (e.) impact the profits

of Nessle Chocolate Corporation

SOLUTION TO DEMONSTRATION PROBLEM 1 a.

b. Yes, they should agree to transfer. Nessle Chocolate Corporation will realize a differential profit of $12 per bushel if the Nut Farm has sufficient surplus capacity for the transfer. If the Nut Farm is already oper-ating at full capacity for current sales, then the differential profit to Nessle will only be $1 per bushel.

c. If the ceiling is used, then all of the transfer's differential profit will appear in the selling division's (Nut Farm) segment margin. The buying division (Chocolate Bar Company) will see no change in its segment margin.

d. If the floor is used, all of the differential profit will appear in the buying division's segment margin (Chocolate Bar Company), while the Nut Farm will have no change in its segment margin.

e. The midpoint of the range of transfer prices is $21.50 per bushel if the Nut Farm has the surplus capac-ity to fill this order or $27.00 per bushel if the Nut Farm has no surplus capacity available. In either situa-tion, the divisions will share equally in the transfer's differential profit ($6.00 per bushel each in the surplus capacity situation, and $0.50 per bushel each in the full capacity situation).

f. If the transfer happens (and in the absence of any cost variances), Nessle Chocolate Corporation should realize an increase in pretax profits of $12 per bushel transferred in the surplus capacity situation or $1 per bushel in the full capacity situation. Nessle's differential profit is not changed if different transfer prices are used (in the absence of certain tax and tariff effects). The transfer price is lust a profit-sharing rule between the two managers.

DEMONSTRATION PROBLEM 2 Managerial motivations and the range of acceptable transfer prices.

a. Discuss how the two divisional managers of the Nessle Chocolate Corporation calculated their opportu-nity costs for the transfer situation above.

b. Why do these opportunity costs create a ceiling and floor for a range of transfer prices that would be acceptable to both managers?

c. In calculating the differential profits that the transfer can create, how does the Nessle Chocolate Corpo-ration view each selling division situation?

Internal variable costs (for transfers):Production costs Other costs

$ 8.00

7.50Totals $15.50 Sales price: Bushels sold to outside customers at $30 each CHOCOLATE BAR DIVISIONPurchase price per bushel from external supplier: $27.50 eachOther variable costs of making chocolate nut bars: 14.00Sales price for chocolate nut bars: 60.00

Range of transfer prices Transferred product Trade with selling division surplus Capacity:

(Exhibit 21-6)

Transferred product taken from normal Customer sales:

Full capacity situation (Exhibit 21-7)CEILING: (determined by

the “buying” division: Chocolate Bar Co.)

External purchase price:

$27.50

External purchase price:

$27.50FLOOR: (determined by the

“selling” division: Nut Farm)

Internal variable cost:

$15.50

External sales price less

variable costs saved by transferring:

$26.50Transfer's differential

contribution margin per bushel of nuts: (for the “company”: Nessle Chocolate)

Ceiling - Floor:

$12.00

Ceiling - Floor:

$1.00


SOLUTION TO DEMONSTRATION PROBLEM 2

a. As the buying division, the Chocolate Bar Company's manager has two alternatives: buying bushels of nuts from a competitor of the Nut Farm for $27.50, or transferring them from the Nut Farm. In the surplus capacity situation, the selling division (the Nut Farm) manager has to at least cover her variable costs for the transferred bushels, which is $15.50. If operating at full capacity for current external sales, she needs to maintain the same contribution margin per bushel that she already is receiving. Since $3.50 per bushel can be saved by transferring versus selling outside, she could pass this savings along to the buying division manager and still maintain her same CMU. The normal sales price is $30.00, which, less this savings of $3.50, results in a transfer price of $26.50 that will preserve her current contribution margin per bushel.

b. The external purchase cost for the Chocolate Bar Company is the ceiling of the range of mutually acceptable transfer prices because this manager can accept any transfer price up to this amount without his CMU going down. The Nut Farm manager, as the selling division, must receive a transfer price equal to or greater than her floor price calculated in (a). If the transfer price equals the floor, there will be no increase or decrease in her segment margin. If the transfer price is some amount above the floor, then that difference will be extra profit to her. Thus, she has no limit on how high the transfer price can be, just on how low it can go. Conversely, the buying division manager has a limit on how high the transfer price can go, but not on how low it can be. Any transfer price within the range created by these opportunity costs will be accept-able to each manager.

c. In the surplus capacity situation, the Nessle Chocolate Corporation views a transfer as a simple make-or-buy decision. It can make a bushel of nuts in the Nut Farm Division or buy it through the Chocolate Bar Company. It will want to transfer (“make”) whenever that cost (the floor) is less than the cost of buying externally. Nessle views the full capacity situation as a sell-or-process-further decision. Bushels of nuts can he sold now or processed further into chocolate nut bars. If the money saved by processing further (trans-ferring) is greater than the contribution margin per bushel currently being made by the Nut Farm, then Nessle will want a transfer.

REVIEW QUESTIONS21.1 Define a transfer.21.2 Distinguish between a transfer and a “normal” sale between two unrelated parties. Why is this an

important distinction?21.3 What is the distinction between components arid intermediate products, and why is it important in

choosing a transfer policy?21.4 What is the objective of the management accounting system for transfers from a cost center?21.5 What three managerial roles are involved in a transfer?21.6 What are the information needs for each managerial role identified in Question 21.5 if the divisions

are profit centers and transfers are optional? Consider the questions the manager wants answered in each case.

21.7 What are the responsibilities of a cost center manager who transfers components.21.8 What are the responsibilities of profit center managers who receive transferred components?21.9 What are the management accounting system's objectives for a transfer costing policy between a cost

center and a profit center?21.10 What are the three issues a management accountant must address in recommending a transfer cost-

ing policy? 21.11 Why should a transfer costing policy use the standard absorptive manufacturing cost of the trans-

ferred component as the transfer cost?21.12 Why is standard absorptive manufacturing cost preferred over standard variable manufacturing cost

as a transfer cost?21.13 What is a “pseudo profit center,” and how can a transfer costing system create one?21.14 List two reasons why companies might want to create pseudo profit centers through the choice of a

transfer costing policy.21.15 When a profit center is required to transfer an intermediate product, why is standard absorptive man-

ufacturing cost a good choice for the transfer price? 21.16 List the two goals for a transfer pricing policy when transfers are optional. 21.17 What is the ceiling transfer price within the Transfer Pricing Matrix? 21.18 What is the floor transfer price within the Transfer Pricing Matrix?

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21.19 Why does the overall company view an optional transfer between profit centers as simply a make-or-buy decision when there is sufficient surplus capacity for the transfer within the selling divi-sion?

21.20 Explain why a range of mutually acceptable transfer prices exists whenever the transfer will gener-ate a differential profit for the company.

21.21 In optional profit center transfers, why does the floor price change if the selling division does not have sufficient surplus capacity for the transfer?

21.22 The overall company views an optional transfer between profit centers as a sell-or-process-further decision when the selling division is currently at full capacity production. Why?

21.23 In optional transfers between profit centers, how does the transfer price affect the reported profits of each of the three parties involved?

21.24 In optional transfers between profit centers, what is the effect on each division's income statement from setting the transfer price at the ceiling of the range of transfer prices? At the floor? At the midpoint of the range?

21.25 List the four types of reward systems and the transfer price policy recommended for each in optional profit center transfers.

21.26 What are the costs and benefits from requiring a transfer price to be negotiated in optional profit center transfer situations?

CHAPTER-SPECIFIC PROBLEMSThese problems require responses based directly on concepts and techniques presented in the text.

21.27 Optional transfers between profit centers. TAA, a multidivisional telecommunications corporation, has two completely independent profit centers considering a transfer. The Interstate Commerce Commis-sion of the U.S. government has mandated that TAA subsidiaries operate within a decentralized environ-ment. Thus, TAA cannot dictate transfers or impose a transfer pricing policy on the divisions. They must be free to decide whether they should transfer, and if so, they must negotiate a transfer price. Further, the TAA reward system must be based on the total divisional profits reported by the profit centers.

One of TAA's divisions, Southwestern Ringer, produces telephone sets that it sells for $30 each. The stan-dard absorptive manufacturing cost is $24, which includes $6 per unit in fixed overhead. The fixed over-head is allocated over its annual sales forecast of 50,000 telephone sets. its maximum production capacity is 75,000 sets annually.

Another division, Northeastern Tell, can use the telephone sets in an answering machine-telephone-radio product it markets. As an alternative to buying telephone sets from Southwestern, Northeastern can enter into a contract for the 20,000 sets needed from a Mexican company, OLA Inc. OLA has quoted a price of $25 per set for the same quality telephone.

Required:

a. Determine whether a transfer should take place between Southwestern Ringer and Northeastern Tell.b. Should a transfer occur if Southwestern can increase its sales and production volumes to 75,000 sets

annually by dropping the sales price to $27.50?

21.28 Managerial motivations and transfer pricing policies. In the previous problem, the two divisional managers cannot agree on a transfer price. The Southwestern manager maintains that the transfer price should be his current sales price of $30 per telephone, because the ICC requires that the divisions act as independent entities. The Northeastern manager insists on the floor price, claiming that incremental pro-duction costs are only $18 and that it will not produce the 20,000 phones if Southwestern does not transfer them because there is no other market for the phones.

Required: Although, as the corporate accountant for TAA, you cannot set a policy for interdivisional trans-fers, TAA management has asked you to evaluate the managers' claims and recommend a transfer price. Prepare a memo to the corporate vice president.

21.29 Transfers with differential fixed costs. Refer to Problem 21.27. Northeastern Tell wants its name imprinted on the telephone set. Its Mexican supplier has quoted a price of $31.00 per set. Southwestern Ringer will have to buy a stamping machine at a net cost of $20,000. Southwestern no longer can produce at full capacity by dropping its sales price to $27.50, so the manager has abandoned that idea.


Required: Determine whether there should now be a transfer. What transfer price will result in the manag-ers benefiting equally from the transfer?

21.30 Limited capacity transfers. Continuing the TAA example from the previous problem, the Northeast-ern marketing staff has decided against imprinting its name on the phone. However, they believe that it the color is changed to fuchsia, 30,000 specialty phone-answering machine-radios can he sold in the greater New York area. The Mexican supplier has quoted a price of $26.50 for an order of this size due to the higher cost of processing fuchsia. Southwestern already produces fuchsia-colored phones for its Los Ange-les market and will incur no extra costs in changing the color.

Required: Calculate whether this transfer should occur. If so, what transfer price will share the differential profits equally between the two managers?

21.31 Imputing the ceiling price. The Northeastern marketing staff has always been known for their cre-ativity. Now they are considering changing the color of their specialty phone product to paisley. The Mexi-can supplier will not even bid on this, and no other supplier has been found. Northeastern believes that 22,500 of these specialty phone products can be sold at $200 each in the Atlantic City market. The costs to produce this product, other than the cost of the Southwestern phone set, are $183 each. Fortunately, South-western already produces a paisley phone for its San Francisco market. While this phone's cost structure is the same as Southwestern's other phones, it can only be sold for $20.

Required: Determine whether a transfer is profitable for TAA. If so, suggest a transfer price that shares TAA's differential profit 75% for Northeastern and 25% for Southwestern.

21.32 Optional profit center transfers. Returning to the Nessle Chocolate Corporation demonstration problem, the Nut Farm management has just offered the California Pickers Union a new contract in the hopes of averting a labor strike. The new contract will increase standard direct labor costs by $2. New picking and sorting machinery promised in the contract will increase budgeted fixed production costs by $10,000 per year. Per bushel nut prices cannot he increased because of intense competition internationally. Chocolate Bar Company is not affected by the threatened strike as it has been importing nuts from a Bra-zilian supplier for $25.50 per bushel.

Required:

a. Should the Nut Farm and the Chocolate Bar Company managers agree to transferring nuts?b. Assume the new President of the United States extends the Free Trade Agreement with Mexico to South

American countries. With the elimination of the tariff on Brazilian nuts, the price per bushel will decrease $10. Should the two divisions transfer in this situation?

21.33 Insufficient capacity for the transfer. Continuing Problem 21.32, requirement (a), Chocolate Bar Company wants a transfer of 600 bushels. The Nut Farm manager, after consulting her sales manager, agrees that their normal business will not be lost in the long run by accepting this order.

Required: Should the two managers agree to transfer? What transfer price will equally share the differen-tial profit (if there is one) between them?

21.34 Differential fixed costs and profit center transfers. Use the original information from the Nessle Chocolate Corporation demonstration problems. Because the Food and Drug Administration has recently investigated one of its competitors, Chocolate Bar Company wants to change the size of the broken nut pieces used in its candy bar. Bigger pieces will require the purchase of a special nutcracker machine. The Nut Farm has agreed to buy this machine, which will only be used for transferred nuts, and the cost will be recaptured through this order.

Required:

a. If the transfer order is for 400 bushels, and the cost of the Machine (after disposal) is $4,000, should the managers agree to transfer?

b. What are the midpoints of the range of acceptable transfer prices for both the surplus capacity and the full capacity situations?

21.35 Limited capacity and variable cost savings. [CMA adapted] National industries is a highly decen-tralized corporation with independent operating divisions. Each division is evaluated and rewarded based on its total net income. One of the divisions, Windair, manufactures and sells air conditioners. It is project-ing a sales forecast of 17,400 for next year.

Another division, Koolsource, makes and sells compressors. Its projected income statement for next year follows:

CHAPTER 21


Koolsource has the capacity to produce 75,000 compressors annually. Windair, currently purchasing from an outside source at $70, proposes that Koolsource transfer compressors to them at a transfer price of $50. The Windair manager justified the low bid based on some cost savings that should be realized if compres-sors are transferred. Because specifications for this compressor are slightly different from Koolsource's standard model, $1.50 per compressor of direct materials cost can be saved and no variable selling expenses will be incurred on compressors transferred.

Required:

a. Compute the estimated effect on Koolsource's net income if the 17,400 compressors are transferred at $50 each.

b. Determine whether it would be in National Industries' best interests for Koolsource to transfer compres-sors at $50 each.

c. What is the minimum transfer price you would accept as the Koolsource manager? Defend your answer.

21.36 Government contracting and imputed ceilings. [CMA adapted] Gunco Corporation has two divi-sions, Ajax and Defco. Both are profit centers. One of the products Ajax manufactures is electrical fitting 1726, which is protected under patent and, thus, is not available from any other source. Its variable costs are $4.25 per unit, and its normal sales price is $7.50.

Delco has just been awarded an Air Force contract for the manufacture of a special brake unit. Because Defco was only operating at 50% capacity, it purposefully bid low to increase its chances of winning the contract in what, the manager believed, would be a very competitive process, due to the sagging state of the defense contracting and airline manufacturing industries. The brake's bid sheet shows:

Required:

a. Recommend whether or not Ajax should supply fitting 1726 to Defco.b. Discuss whether a transfer is in Gunco's short-run economic interest.c. Recommend to the Gunco president a transfer policy for situations such as this.

Koolsource Division pro forma Income Statement

for Next YearPer Unit Totals

Sales revenues $100 $6,400,000Less cost of goods sold: Direct materials 12 768,000Direct labor 8 512,000Variable overhead 10 640,000Fixed overhead 11 704,000Total COGS <$ 41> <$2,624,000>Gross profit $ 59 $3,776,000

Operating expenses: Variable selling expenses $ 6 $ 384,000Fixed selling expenses 4 256,000Fixed administrative expenses 7 448,000Total operating expenses <$ 17> <$1,088,000>Pretax net income $ 42 $2,688,000

Purchased parts from outside vendors $22.50Ajax electrical fitting 1726 5.00Other variable costs 14.00Standard variable manufacturing and delivery costs $41.50Indirect cost markup for fixed factory overhead, administration costs, and profit

8.00

Brake bid price $49.50


THINK-TANK PROBLEMSAlthough these problems are based on chapter material, reading extra material, reviewing previous chap-ters, and using creativity may be required to develop workable solutions.

21.37 Considering the type of product and responsibility centers in choosing a transfer costing (pricing) policy. What is the relationship between components and intermediate products with respect to cost centers and profit centers? Why is it important to consider the type of part, and the responsibility center transfer-ring it, in choosing a transfer costing (pricing) policy?

21.38 Actual versus standard costs in transfer costing. Discuss the transfer costing policy issues dealing with the use of actual versus standard cost in transferring components. Include a numeric example to illus-trate your points.

21.39 Markups and transfer costing. Discuss the transfer costing policy issues involved in using a “marked-up” transfer cost.

21.40 Using market price for transfers. Discuss the implications for the transferring division, the receiving division,. and the overall company from using a transfer policy based on the external sales price of a part.

21.41 Quality information as a goal for the transfer pricing policy. Producing quality information is a “key rule” for management accounting. In Chapter 1, five attributes of quality information were identified. Discuss the implications of each attribute when designing a transfer pricing policy.

21.42 Ethics in optional profit center transfers. In Chapter 1, four ethical standards of conduct were iden-tified. Discuss the implications of these for the management accountant when designing a transfer pricing policy for optional profit center transfers.

21.43 Transfers from a just-in-time producer. Itsosweet Candy Corporation (ICC), a highly decentralized national manufacturer of confections, has just acquired a new subsidiary company, the Thomas Lollipop Company (TLC). One of the products TLC makes is a Valentine's Day lollipop. This heart-shaped lollipop contains two chocolate secret centers and has two sticks coming out of the bottom. Historically, TLC has purchased chocolate centers from a South American supplier, but chocolate prices have become very vola-tile over the past few years.

ICC has a subsidiary, Chocolate Forever Company (CFC), that can produce these secret centers for TLC. CFC is currently a cost center for ICC, with a flexible manufacturing process that produces chocolate products using JIT procedures. CFC estimates a standard absorptive manufacturing cost for secret centers to be $0.08. The standard fixed overhead cost is $0.03. A per-kanban setup cost of $50.00 is not included in the standard cost, however. Currently, TLC expects the purchase price of secret centers to remain some-what stable at $0.06 each.

Required: Recommend a transfer policy if ICC requires TLC to obtain secret centers from CFC. Consider a second situation: The CFC plant manager presents a proposal to ICC to become a profit center. ICC agrees, but still requires that CFC supply secret centers to TLC whenever there are no kanbans for other chocolate products. The CFC manager sets a normal sales price for secret centers at $0.085, while budget-ing a standard variable cost of $0.05 per secret center. Recommend a transfer policy for this situation. Does your recommendation change if the majority of CFC's output becomes secret centers transferred to TLC? With both recommendations, consider how the transfer policies are affected by a JIT supplying division.

21.44 Transfers from a JIT profit center. Continuing the situation in the previous problem, TLC argues that because of the volatility in South American chocolate prices, ICC should allow transfers to be optional, and any differential profits resulting from transfers should be shared between the TLC and CFC divisions. 1CC agrees, but doesn't want to get involved in determining how the differential profits should be shared between the divisions because of its commitment to decentralized decision making. ICC rewards profit centers based on their aggregate divisional profit.

Required:

Recommend a transfer policy and a transfer price for this situation assuming the South American price remains stable. Should the two divisions be transferring secret centers? Would your answer change if the price of South American secret centers dropped to $0.055 each? What if it dropped to $0.05? Now assume that TLC wants to issue a production kanban to CFC for 10,000 secret centers. What is the break-even South American price for secret centers?

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21.45 Negotiation failure. Continuing the situation in the previous problems, assume the TLC and CFC managers are negotiating a transfer. The TLC manager demands a transfer price of $0.05. The CFC man-ager demands a transfer price of $0.06, the current South American price. Also assume that there will be no per-kanban setup costs for this transfer and that CFC has the surplus capacity for it. Play the role of each manager and “make your case” for that transfer price. Why is each manager motivated to argue for these transfer prices? Finally, play the role of the ICC vice president in charge of these two profit centers. In this role, what would you do? J


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Chapter 21 : Product Transfers Within A Company

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