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19) If a supplying division has excess capacity, the best transfer price is the product’s variable cost. 20) If a product has an external market and divisions are treated as profit centres, cost-based transfer prices can often lead to suboptimal decisions. 21) In a dual-rate transfer pricing system, the selling department is credited for the market price and the buying department is charged the product’s variable cost. 22) Transfer pricing policies can affect a company’s tax liability, particularly if it does business internationally. 23) A company with subsidiaries located in both high and low tax countries could charge a low transfer price in the high-tax countries so that most of the contribution margin arises where taxes are the lowest. ANSWERS TO TRUE-FALSE STATEMENTS Item Ans. Item Ans. Item Ans. Item Ans. 1. F 7. T 13. F 19. T 2. F 8. F 14. F 20. T 3. T 9. T 15. F 21. T 4. T 10. T 16. T 22. T 5. T 11. F 17. F 23. F 6. T 12. T 18. T Chapter 13: Pricing Decisions 13-3

13-6 Cost Management c) Whether or not the product is a commodity d) The cost to produce the product 29) Which of the following is a formal method for incorporating demand into prices? a) Cost-based pricing b) Market-based pricing c) Price elasticity of demand d) Price elasticity of supply 30) Which of the following formulas calculates price elasticity of demand? a) ln (1 + % change in quantity sold) / ln (1 + % change in price) b) (1 + % change in quantity sold) / (1 + % change in price) c) % change in quantity sold / % change in price d) ln (1 - % change in quantity sold) / ln (1 - % change in price) 31) Which of the following formulas calculates the profit-maximizing price? a) Total variable cost + total fixed cost b) (Total variable cost + total fixed cost) / price elasticity of demand c) Variable cost × [elasticity / (elasticity + 1)] d) Total cost × [elasticity / (elasticity + 1)] 32) Which of the following factors affect a product’s profit-maximizing price? I. Fixed costs II. Price elasticity of demand III. Variable costs a) I and III b) II and III c) I and II d) I, II, and III 33) Market-based prices are normally determined using some measure of: a) Supplier prices b) Supplier demand c) Customer demand d) Degree of governmental regulation

c) Inability to operate profitably d) Tendency to make poor decisions relative to cost-based pricing 44) The most commonly used pricing method in Canada is: a) Market-based pricing b) Life cycle pricing c) Zero-based pricing d) Cost-based pricing 45) Which of the following is an example of a product with elastic demand? a) Cigarettes b) Customized homes c) Gasoline d) High fashion clothing 46) What do accountants use to estimate the effects of price changes on sales volume? a) Market prices b) Historical prices c) Competitor prices d) Forecasted prices 47) Charging different prices at different times to reduce capacity constraints is called a) Penetration pricing b) Transfer pricing c) Peak load pricing d) Price skimming 48) The practice of charging higher prices for products or services when they are first introduced is known as: a) Transfer pricing b) Price skimming c) Peak load pricing d) Price gouging 49) Which pricing method is used to capture market share by charging low introductory prices Chapter 13: Pricing Decisions 13-9

13-12 Cost Management 60) Anti-dumping tariffs in Canada are set so that: a) A foreign product’s price will be equivalent to the price charged by Canadian companies b) A foreign product’s price will be higher than the price charged by Canadian companies c) A Canadian company’s price will be lower than the price charged by a foreign company d) Customers will always be motivated to purchase products from Canadian companies 61) Certain highways in British Columbia require users to pay a toll for their use. Toll prices vary according to the time of day, demonstrating the use of: a) Penetration pricing b) Cost-based pricing c) Price skimming d) Peak load pricing 62) Under what circumstances is penetration pricing considered legal in Canada? a) Penetration pricing is never considered legal in Canada b) Penetration pricing is not legal if the industry is regulated c) Penetration pricing is not legal if it is considered predatory pricing d) Penetration pricing is legal only if the industry is regulated 63) Under Canadian laws, which of the following statements is the best example of the process known as dumping? a) A Canadian company with excess inventory sells its product for a price below cost b) A foreign company sells its products in Canada for less than the market value in the country where the products are manufactured. c) A foreign company with excess inventory sells it in its home country for a price below the normal selling price d) A company with a new product sells it in Canada for a price above the normal selling price 64) The Mukilteo Division of Snohomish Corp. produces and sells a product to outside and internal customers. Per-unit data collected from its operations include: Outside sales price $640 Direct materials 105 Direct labour 250 Fixed overhead 180 If Mukilteo is operating at full capacity and selling solely to outside customers, what price

d) $225.000 lower 70) Division A of Sibley, Inc. has operating data as follows: Capacity 20,000 units Selling price $80 per unit Variable costs $45 per unit Fixed costs $20 per unit Division B wants to purchase units from Division A. If Division A agrees to sell units to Division B, A’s variable costs will be $5 less per unit. If Division A is operating at capacity, what is the minimum price it should charge? a) $40 b) $75 c) $20 d) $60 71) Division A of Sibley, Inc. has operating data as follows: Capacity 20,000 units Selling price $80 per unit Variable costs $45 per unit Fixed costs $20 per unit Division B wants to purchase units from Division A. If Division A agrees to sell units to Division B, A’s variable costs will be $5 less per unit. If Division A has capacity available to meet B’s requirements, what is the minimum price it should charge? a) $40 b) $75 c) $20 d) $60 72) Division A produces a component for Hielkema Company’s main product — automobiles. The division operates as a profit centre. It also sells to outsiders. The present selling price is $75 per component. The company buys 600,000 units of a similar component per year from outside sources. The external purchase price is $73 as a result of a quantity discount. Division A has adequate capacity to supply the needs of the Assembly division. The following data are for Division A: Direct material $30 per unit Direct labour $25 per unit Chapter 13: Pricing Decisions13-15

13-18 Cost Management a) Market price is unknown b) Selling department has excess capacity c) Market price is higher than the variable cost d) Market price is higher than the full cost 82) Which of the following transfer pricing systems potentially takes the most time to establish? a) Market-based b) Dual-rate c) Negotiated d) Full-cost 83) Division S sold a part to both Division P and outside customers last year. The revenues from these sales were $30,000 (1,000 units) and $35,000 (1,000 units), respectively. Next year, S plans to increase the unit sales price to $42 and wants a proportionate increase in the sales price to Division P. The unit costs are $9 variable and $15 fixed. If Division P does not agree to the price increase, 50% of Division S’s fixed costs will be eliminated. What is the highest price Division P would be willing to pay for external purchases? a) $30.00 b) $36.00 c) $16.50 d) $28.50 84) The Machining Division has a capacity of 2,000 units. Its sales and cost data are: Selling price per unit $100 Variable manufacturing costs per unit $25 Variable administrative costs per unit $5 Total fixed manufacturing overhead $20,000 Total fixed administrative costs $5,000 The Machining Division is currently selling 1,900 units to outside customers, and the Assembly Division wants to purchase 300 units from Machining. If the transaction takes place, the variable administrative costs per unit on the units transferred to Assembly will be $2/unit, not $5/unit. What should be the transfer price? a) $73.67 b) $76.67 c) $97.00 d) $100.00

c) Transfer prices must be lower than those in an arm’s length transaction d) Transfer prices may be at any price approved by both related parties 92) What is the best transfer price policy? a) Opportunity cost approach b) Market based approach c) Cost based approach d) Market cost approach 93) In Canada, predatory pricing occurs when: a) A foreign company dumps product in Canada at prices below the market value in the country where they were manufactured b) Two organizations conspire to set prices c) An organization prices products or services very low to drive out competition and increase market share d) An organization sets a low price to introduce a new product 94) Price elasticity of demand: a) Is a price based on total cost with a desired mark-up b) Indicates the sensitivity of sales to changes in price c) Is a price based on variable cost with a desired mark-up d) Is a calculation that relates changes in costs to changes in volume of sales 95) The death spiral is: I. Setting prices very low II. Two organizations conspiring to set prices III. A problem of prices based on average cost and declining sales a) I b) III c) I and III d) II and III 96) Market-based pricing: a) Uses a traditional mark-up b) Calculates price based on total cost c) Considers demand and competitors’ prices Chapter 13: Pricing Decisions13-21

13-22 Cost Management d) Considers current costs and future costs in setting prices 97) In Canada, dumping is: I. Selling a product at a price that is below the market price II. Not a legal problem for Canadian companies that have no foreign subsidiaries III. Prosecuted by setting tariffs a) I and II b) I, II, and III c) I and III d) II and III 98) Prices that are calculated using elasticities: a) Always result in profit maximization b) Are very common c) Ignore customer demand d) Develop a mark-up for variable cost 99) Not-for-profit pricing decisions: I. Are made using the same practices as for-profit pricing decisions II. Sometimes result in different prices for different customers III. Sometimes subsidize particular groups of people a) I and II b) II and III c) I, II, and III d) III 100) The Internet and global competition: a) Have not changed pricing practices b) Have increased the use of market-based pricing c) Do not provide more information about prices d) Have increased the use of cost-based pricing 101) The Internet: a) Makes it more difficult to use JIT production systems b) Has not affected the relationship between manufacturers and suppliers

c) Allows suppliers to monitor their customers’ inventory levels and provide new inventories just as needed d) Makes it more difficult to practice target costing 102) Dyggur Traders wishes to earn a 30% return on its $100,000 investment in equipment used to produce dog toys. Based on estimated sales of 10,000 toys next year, the costs per unit would be as follows: Variable cost $5.00 Fixed selling and administrative costs 2.00 Fixed manufacturing cost 1.00 At how much per unit should dog toys be priced for sale? a) $11.00 b) $9.00 c) $12.00 d) None of the above 103) Transfer prices are used to value all of the following except: a) Internal transfers of products b) Internal transfers of services c) Transfers to unrelated businesses d) Transfers to other divisions in the same company 104) Governments often require the following type of transfer price for income taxes: a) Variable cost b) Dual rate c) Market price d) Activity based cost 105) Which of the following is most likely to be the lowest transfer price? a) Variable cost b) Dual-rate c) Market price d) Activity based cost 106) Which of the following is most likely to be the highest transfer price? a) Variable cost Chapter 13: Pricing Decisions13-23

13-24 Cost Management b) Dual-rate c) Market price d) Activity-based cost 107) An advantage of using negotiated transfer prices is: a) Both the selling and buying units have complete information about costs b) It may take more of managers’ time than is beneficial for the company c) The market price will always be chosen d) Once the price is set, it never needs to be adjusted 108) A transfer price that reduces suboptimal decisions without consuming a lot of time is a) Variable cost b) Dual-rate price c) Market price d) Activity-based cost 109) Adler Industries is a vertically integrated firm with several divisions that operate as decentralized profit centres. Adler’s System Division manufactures scientific instruments and uses the products of two of Adler’s other divisions. The Board Division manufactures printed circuit boards (PCBs). One PCB model is made exclusively for the Systems Division using proprietary designs, while less complex models are sold in outside markets. The products of the Transistor Division are sold in a well-developed competitive market; however, one transistor model is also used by the Systems Division. The costs per unit of the products used by the systems Division are presented below: PCB Transistor Direct materials $2.50 $0.80 Direct labour 4.50 1.00 Variable overhead 2.00 0.50 Fixed overhead 0.80 0.75 Total cost $9.80 $3.05 The Board Division sells its commercial products at full cost plus a 25% markup and believes the proprietary board made for the Systems Division would sell for $12.25 per unit on the open market. The market price of the transistor used by the Systems Division is $3.70 per unit. (CMA) A per unit transfer price from the Transistor Division to the Systems Division at full cost, $3.05, would: a) Allow evaluation of both divisions on a competitive basis b) Satisfy the Transistor Division’s profit desire by allowing recovery of opportunity costs c) Demotivate the Systems Division and cause mediocre performance

d) Provide no profit incentive for the Transistor Division to control or reduce costs 110) Adler Industries is a vertically integrated firm with several divisions that operate as decentralized profit centres. Adler’s System Division manufactures scientific instruments and uses the products of two of Adler’s other divisions. The Board Division manufactures printed circuit boards (PCBs). One PCB model is made exclusively for the Systems Division using proprietary designs, while less complex models are sold in outside markets. The products of the Transistor Division are sold in a well-developed competitive market; however, one transistor model is also used by the Systems Division. The costs per unit of the products used by the systems Division are presented below: PCB Transistor Direct materials $2.50 $0.80 Direct labour 4.50 1.00 Variable overhead 2.00 0.50 Fixed overhead 0.80 0.75 Total cost $9.80 $3.05 The Board Division sells its commercial products at full cost plus a 25% markup and believes the proprietary board made for the Systems Division would sell for $12.25 per unit on the open market. The market price of the transistor used by the Systems Division is $3.70 per unit. (CMA) Assume the Systems Division is able to purchase a large quantity of transistors from an outside source at $2.90 per unit. The Transistor Division, having excess capacity, agrees to lower its transfer price to $2.90 per unit. This action would: a) Optimize the profit goals of the Systems Division while subverting the profit goals of Adler industries b) Optimize the overall profit goals of Adler Industries c) Subvert the profit goals of the Transistor Division while optimizing the profit goals of the Systems Division d) Cause mediocre behaviour in the Transistor Division as lost opportunity costs increase 111) Adler Industries is a vertically integrated firm with several divisions that operate as decentralized profit centres. Adler’s System Division manufactures scientific instruments and uses the products of two of Adler’s other divisions. The Board Division manufactures printed circuit boards (PCBs). One PCB model is made exclusively for the Systems Division using proprietary designs, while less complex models are sold in outside markets. The products of the Transistor Division are sold in a well-developed competitive market; however, one transistor model is also used by the Systems Division. The costs per unit of the products used by the systems Division are presented below: PCB Transistor Direct materials $2.50 $0.80 Direct labour 4.50 1.00 Variable overhead 2.00 0.50 Chapter 13: Pricing Decisions13-25

13-26 Cost Management Fixed overhead 0.80 0.75 Total cost $9.80 $3.05 The Board Division sells its commercial products at full cost plus a 25% markup and believes the proprietary board made for the Systems Division would sell for $12.25 per unit on the open market. The market price of the transistor used by the Systems Division is $3.70 per unit. (CMA) The Board and Systems Divisions have negotiated a transfer price of $11.00 per printed circuit board. This price will: a) Cause the Board Division to reduce the number of commercial printed circuit boards it manufactures b) Motivate both divisions as estimated profits are shared c) Encourage the Systems Division to seek an outside source for printed circuit boards d) Demotivate the Board Division causing mediocre performance ANSWERS TO MULTIPLE CHOICE QUESTIONS Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. Item Ans. 24. c 40. b 56. c 72. d 88. a 104. c 25. c 41. b 57. c 73. b 89. b 105. a 26. a 42. b 58. c 74. a 90. c 106. c 27. b 43. a 59. a 75. b 91. b 107. a 28. d 44. d 60. a 76. c 92. a 108. b 29. c 45. a 61. d 77. c 93. c 109. d 30. a 46. b 62. c 78. c 94. b 110. b 31. c 47. c 63. b 79. a 95. b 111. b 32. b 48. b 64. c 80. d 96. c 33. c 49. a 65. b 81. b 97. b 34. a 50. b 66. c 82. c 98. d 35. d 51. b 67. d 83. b 99. b 36. a 52. a 68. c 84. a 100. b 37. c 53. a 69. b 85. b 101. c 38. a 54. c 70. a 86. b 102. a 39. d 55. a 71. a 87. c 103. a

Matching Questions 112) Several terms related to product pricing are listed below on the left. Potential definitions are listed on the right. Match the lettered items on the right with the appropriate item on the left. Each numbered item has only one correct answer. Each lettered item may be used only once. ____ 1. Collusive pricing ____ 2. Death spiral ____ 3. Dumping ____ 4. Peak load pricing ____ 5. Penetration pricing ____ 6. Predatory pricing ____ 7. Price discrimination ____ 8. Price gouging ____ 9. Price skimming ____ 10. Transfer pricing A. Associated with an organization’s internal transactions B. Can be justified by cost differences C. Charging higher prices when a product is first introduced D. Charging prices that consumers see as excessive E. May occur when sales volumes inappropriately influence prices F. Multiple organizations work together to set prices above competitive levels G. Often counteracted in Canada by imposing tariffs H. Often used to deal with capacity constraints I. Setting different prices for different customers J. Setting lower prices during product introduction to capture market share Answer: 1. F 2. E 3. G 4. H 5. J 6. B 7. I 8. D 9. C 10. A Chapter 13: Pricing Decisions13-27

13-28 Cost Management 113) Indicate whether each transfer price below is (A) cost-based, (B) activity-based, (C) market-based, (D) dual-rate, or (E) negotiated. ____ 1. Require end-of-period adjustments for accurate organizational profit reporting ____ 2. Is required by the CRA and other international government taxing authorities ____ 3. Ensures that both managers have full information about costs and market prices ____ 4. Enhances organizational planning through accurate forecasts of internal demand ____ 5. Commonly used when no external market exists Answer: 1. D 2. C 3. E 4. B 5. A Exercises 114) SRB Corporation manufactures and sells espresso machines for $80 each. In a recent accounting period, SRB incurred the following costs to produce 5,000 espresso machines: Direct material $ 18,250 Direct labour 36,250 Variable manufacturing overhead 22,250 Fixed manufacturing overhead 19,000 Variable nonmanufacturing costs 19,750 Fixed nonmanufacturing costs 21,000 Total $136,500 Assume that SRB plans to increase the price of its current espresso machines by 30% next year, with a resultant 40% drop in unit sales. Use the appropriate natural logarithms below to calculate the indicated amounts: ln (0.1) = -2.303 ln (0.6) = -0.511 ln (1.1) = 0.095 ln (0.3) = -1.204 ln (0.7) = -0.357 ln (1.3) = 0.262 a) Price elasticity of demand b) Profit maximizing price c) Total cost per unit to achieve a 30% profit margin Solution to Exercise 114 a) Price elasticity of demand = -0.511 / 0.262 = -1.950

b) Profit maximizing price = -1.950 / -0.950 * $96,500 / 5,000 = $39.62 c) Total cost per unit = $39.62 * (1-30%) = $27.73 115) GYG Corporation manufactures and sells wine racks for $120 each. In a recent accounting period, GYG incurred the following costs to produce 300 racks: Direct material $ 4,095 Direct labour 5,175 Variable manufacturing overhead 4,335 Fixed manufacturing overhead 1,140 Variable nonmanufacturing costs 4,185 Fixed nonmanufacturing costs 1,260 Total $20,190 a) GYG’s marketing research department has proposed developing a better quality rack, which would sell for a price of $120. Top management will accept the proposal provided the profit margin is 40%. Calculate the target cost per unit for the new wine racks. b) Recent market research has suggested GYG should sell the existing wine racks for $100 each. Calculate the percentage decrease required for each cost category listed above, assuming a 40% profit margin and proportional cost reduction across categories. c) Ignore the information in part (b). Suppose GYG anticipates that the quantity demanded for its current wine racks will increase by 40% in the coming year. Assume that operations remain within the relevant range. Calculate the following amounts assuming GYG uses a 70% mark-up on total cost (including per-unit fixed costs) to determine product prices: 1) Total costs 2) Price per wine rack 3) Total profit d) Ignore the information in parts (b) and (c). Assume that GYG plans to increase the price of its current wine rack by 30% next year and expects a resultant 40% drop in unit sales. Use the appropriate natural logarithms below to calculate the indicated amounts. ln (0.1) = -2.303 ln (0.6) = -0.511 ln (1.1) = 0.095 ln (0.3) = -1.204 ln (0.7) = -0.357 ln (1.3) = 0.262 1) Price elasticity of demand. 2) Profit maximizing price. 3) Total cost per unit to achieve a 30% profit margin. Solution to Exercise 115 a) Target cost for new product = $120 * 60% = $72 b) Kaizen costing for existing product: Target cost = $100 * 60% = $60 per unit Total target cost = 300 units * $60 per unit = $18,000 Required cost reduction for each cost category = ($20,190 - $18,000) / $20,190 = 10.85% c) Cost-based pricing 1) Need to determine the cost function: Chapter 13: Pricing Decisions13-29

13-30 Cost Management Variable cost per unit = ($4,095 + $5,175 + $4,335 + $4,185)/300 = $59.30 per unit Fixed costs = $1,140 + $1,260 = $2,400 New volume = 300 units * 1.4 = 420 units Total cost at 420 units = $2,400 + 420 * $59.30 = $27,306 2) Total cost per unit = $27,306 / 420 units = $65.01 Cost-based price = $65.01 * 1.70 = $110.52 3) Total revenue 420 units * $110.52 $46,418.40 Total cost (per 1 above) 27,306 .00 Total profit $19,112 .40 d) Market-based pricing 1) Price elasticity of demand = -0.511 / 0.262 = -1.950 2) Profit maximizing price = (-1.950 / -0.950) * ($17,790 / 300) = $121.72 3) Total cost per unit = $121.72 * (1-30%) = $85.20 116) Aberzombie, Inc. has 2 divisions, Alpha and Beta. Beta produces a unit that sells for $50, with the following costs based on its capacity of 250,000 units: Direct materials $15.00 Direct labour 12.50 Variable overhead 2.50 Fixed overhead 7.50 At present Beta does not sell any units to Alpha. Beta is selling 150,000 units externally, and Alpha is purchasing 75,000 units from an outside supplier for $45 per unit. a) Determine the benefit, if any, to Beta in meeting the outside supplier’s price. b) Determine the lowest price Beta would be willing to accept. c) Assume that a transfer price of $50 is used between Alpha and Beta. Determine the effect on the profits of Alpha, Beta, and Aberzombie, Inc. Solution to Exercise 116 a) Benefit to Beta = 75,000 * ($45 - $30) = $1,125,000 b) Lowest acceptable price for Beta = variable cost = $30 c) Increase in Aberzombie’s profits = 75,000 * ($45 - $30) = $1,125,000 Increase in Beta’s profits = 75,000 * ($50 - $30) = $1,500,000 Decrease in Alpha’s profits = 75,000 * ($50 - $45) = $375,000 Short Answer Questions 117) Describe market-based pricing and give an example of a product for which this pricing method would be appropriate. Solution to Question 117

Market-based pricing is the practice of setting prices using some measure of customer demand. There are many different ways to determine a market-based price, including observation of competitors’ prices, published market prices, findings from market research, and use of a profit- maximizing price formula. Market-based pricing may be used for many different types of products, so student answers to the second part of this question will vary. An example of a product for which market-based pricing is appropriate is a commodity such as oranges or orange juice. Another example is retail items such as electronic goods. 118) Describe cost-based pricing and give an example of a product for which this pricing method would be appropriate. Solution to Question 118 Cost-based pricing is a mark-up of some level of cost, such as variable cost or variable cost plus some allocation of fixed costs. This price provides the company some measure of return (assuming that sales occur). A product that would be appropriately priced using cost-based pricing would be a customized item such as hand-tailored clothing or home remodelling. Student answers will vary. 119) Explain why market-based pricing has increased in recent years. Solution to Question 119 Market-based pricing has increased for several reasons. First, it has become easier to collect data about price and demand. Optical character readers track inventory and price, and the data can be used to determine a profit maximizing price. Some software makers have developed pricing programs using this technique. In addition, competitive price information is more readily available, such as on the Internet. 120) List one advantage and one disadvantage for each of the following pricing methods: market-based and cost-based. Solution to Question 120 An advantage of cost-based pricing is that it is relatively easy to perform. A mark-up is just added to the product’s cost, which is already tracked in the accounting system. A disadvantage is that if the price is too high, and demand declines, the price will need to be higher because there are fewer units to allocate costs to. This is called the death spiral. Another disadvantage is that cost-based prices may be too low, causing foregone revenues. An advantage of market-based pricing is that products are always competitively priced, and so there is a higher probability of sales. With enough data, a profit maximizing price can be set. A disadvantage is that it can be difficult to estimate an appropriate market-based price, and experimentation may be needed to evaluate price sensitivity. Chapter 13: Pricing Decisions13-31

13-32 Cost Management 121) Define transfer prices in your own words. Describe one conflict that arises in setting transfer prices between two divisions. Solution to Question 121 Transfer prices are the prices set for goods or services that are transferred internally. Conflicts that arise when transfer prices are set include conflicts over which department receives contribution from the units that are transferred. Conflicts also arise over whether units should be sold internally or externally if there are capacity constraints. 122) Other than cost-based prices, list and discuss three options managers have for setting transfer prices and suggest a setting that might be appropriate for each. Solution to Question 122 Options for transfer prices other than cost-based include: activity-based, negotiated, dual-rate, and market-based. Activity-based transfer prices would likely be most appropriate in a company that has an established ABC system. Negotiated transfer prices are best used when managers are honest and display integrity, as well as when organizations have the luxury of time in establishing a transfer pricing policy. Dual-rate transfer prices could be employed effectively when transfer pricing is a new concept in an organization; managers could become accustomed to it before moving to a more equitable arrangement. Market-based transfer prices are appropriate when required by taxing authorities. 123) An ice cream outlet that is part of a regional chain has begun purchasing its ingredients from an outside supplier instead of purchasing from the chain. The products from the outside supplier are cheaper, although the quality is not as high. The transfer price for the products is based on the market price, even though the actual costs that the chain incurs are much lower than the market price. Explain why the outsourcing decision is considered suboptimal. What type of transfer price policy would help to avoid this problem? Solution to Question 123 The outlet makes more profit from purchasing from an outside supplier, although the quality is not as good. Eventually this could lead to a loss of sales, making this a suboptimal decision. This problem is avoided by using variable cost as a transfer price, dual-rate transfer prices, or negotiated transfer prices. Under these three methods, the transfer price would most likely be less than market price, and optimal decisions would be made. Problems

124) SRB Corporation manufactures and sells espresso machines for $80 each. In a recent accounting period, SRB incurred the following costs to produce 5,000 espresso machines: Direct material $ 18,250 Direct labour 36,250 Variable manufacturing overhead 22,250 Fixed manufacturing overhead 59,000 Variable nonmanufacturing costs 19,750 Fixed nonmanufacturing costs 41,000 Total $196,500 a) SRB’s marketing research department has proposed developing a better quality espresso machine, which would sell for a price of $120. Top management will accept the proposal provided the profit margin is 40%. Calculate the target cost per unit for the new wine racks. b) Recent market research has suggested SRB should sell the existing espresso machines for $60 each. Calculate the percentage decrease required for each cost category listed above, assuming a 40% profit margin and proportional cost reduction across categories. c) Ignore the information in part (b). SRB anticipates demand for its current espresso machines will increase by 25% in the coming year. Assume that operations remain within the relevant range. Calculate the following amounts assuming SRB uses a 40% mark-up on total cost (including per-unit fixed costs) to determine product prices: 1) Total costs 2) Price per espresso machine 3) Total profit d) Explain why each of the following is uncertain: 1) Expected customer demand for the espresso machines. 2) Ability to achieve the cost reduction identified in part (b). Solution to Problem 124 a) Target cost for new product = $120 * (1-40%) = $72 b) Kaizen costing for existing product: Target cost = $60 * (1-40%) = $36 per unit Total target cost = 5,000 units * $36 per unit = $180,000 Required cost reduction for each cost category = ($196,500 - $180,000) / $196,500 = 8.4% c) Cost-based pricing 1) Need to determine the cost function: Variable cost per unit = ($18,250 + $36,250 + $22,250 + $19,750)/5,000 = $19.30 per unit Fixed costs = $59,000 + $41,000 = $100,000 New volume = 5,000 units * 1.25 = 6,250 units Total cost at 6,250 units = $100,000 + 6,250 * $19.30 = $220,625 2) Total cost per unit = $220,625 / 6,250 units = $35.30 Cost-based price = $35.30 * 1.40 = $49.42 3) Total revenue 6,250 units * $49.42 $308,875 Total cost (per 1 above) 220,625 Total profit $ 88,250 Chapter 13: Pricing Decisions13-33

13-34 Cost Management d) 1) Customer demand is uncertain because it depends on many factors that cannot be perfectly predicted such as consumers’ tastes, competitors’ product features and prices, etc. 2) The ability to achieve targeted cost reductions depends on a variety of factors that cannot be perfectly predicted such as the ability to negotiate lower prices with suppliers, the willingness of employees to accept lower wages or benefits and/or achieve greater work efficiencies, the ability to redesign the product to require fewer parts or less labour, and the ability to design and implement more efficient production processes. Cost reductions also depend on factors over which the company may have little control such as insurance rates, utility costs, transportation costs, and payroll taxes. 125) The Coffee Revolution sells beverages in a variety of coffee flavours. Data for a recent week appear below: Revenue (1,000 cups @ $1.78 each) $1,780 Cost of ingredients $640 Rent 500 Store attendant 360 1,500 Income $ 280 a) Suppose the company’s policy is to set prices based on a 200% mark-up above variable cost. Calculate the cost-based price per cup. b) Describe one disadvantage of the pricing policy described in part (a). c) The manager estimates that if she were to increase the price of beverages from $1.78 to $1.90 each, weekly volume would be reduced to 850 cups. Estimate the profit-maximizing price per cup. Use the following values in your computations as needed: ln (0.1) = –2.303 ln (0.85) = –0.163 ln (1.1) = 0.095 ln (0.15) = –1.897 ln (0.9) = –0.105 ln (1.15) = 0.140 d) Explain why the manager cannot be certain what volume of sales will occur if she increases the price to $1.90. e) Should Coffee Revolution increase or decrease the current price? What advice can you give the manager on making these changes? Why? Solution to Problem 125 a) Variable cost = $640/1,000 cups = $0.64 per cup Cost-based price = $0.64 + $0.64*200% = $1.92 per cup b) One disadvantage is that the price may be set too high, causing the company to lose business. Another disadvantage is that the price may be too low, causing foregone revenues. c) Price increase = ($1.90-$1.78)/$1.78 = 10% Change in quantity sold = (1,000-850)/1,000 = –15% Price elasticity of demand = ln(0.85)/ln(1.10) = –0.163/0.095 = –1.716 Profit maximizing price = [–1.716/(–1.716 +1)] * $0.64 = $1.53 d) There are many reasons why the manager cannot be certain what volume of sales will occur if she increases the price to $1.90. Here are a couple of reasons; student answers will vary: The relationship between prices and volume are always based on estimates; it is not possible to know

with certainty how changes in price affect customer demand. In addition, changes in circumstances—such as changing customer tastes and changes in competition—can change the price elasticity of demand over time. e) Based on the calculations in part (c), the price should decrease. A good starting point would be the previous price of $1.78 per cup. Then the price could be slowly decreased further to monitor the increases in demand and overall profitability. At some point demand will no longer increase with decreases in price, or the profit maximizing price will have been reached because the decrease in contribution margin overrides increases in demand. When this point is reached, the price no longer needs to be changed – unless competitors change their prices. 126) Norex Corporation is a manufacturer of electronic equipment. The large, diversified organization is decentralized and has a number of different divisions. The components division makes electronic components that can be sold either internally to the equipment division or sold to outside customers. Currently, the components division is producing a tiny motor that is often used to run fans to cool equipment. The variable cost of making the motors is $15 per unit, the fixed cost is $5, and the market price is $28. Production is 100,000 units. The equipment division uses the motor when assembling small fans that are sold to computer manufacturers. Currently, the equipment division sells 50,000 fans. The additional variable cost for processing the motors into fans is $8 per unit. Top management is re-evaluating Norex’ transfer pricing policies. The managers are considering the following price options: variable cost, fully allocated cost, and market price. a) Assume the components division has enough capacity to meet both internal and external demand. If the transfer price is set using the opportunity cost for the components division, what transfer price would be most appropriate? Explain your reasoning. b) Assume the components division is operating at full capacity and could sell more units to the outside market. If the transfer price is set using the opportunity cost for the components division, what transfer price would be most appropriate? Explain your reasoning. c) Now assume the selling price for fans is $40 per unit, the transfer price is set at variable cost, and the components division could sell all of the units it produces externally. 1. What is the contribution margin for Norex if the motors are sold externally? What is the contribution margin for the components division if the motors are sold externally? 2. What is the contribution margin for Norex if the motors are sold internally? What is the contribution margin for the components division if the motors are sold internally? 3. Would the managers of the components division be willing to sell any units to the equipment division? Explain. 4. Calculate the opportunity cost of selling all of the motors externally. 5. Recommend a transfer price policy to Norex that could potentially solve any problems of suboptimal decision-making. Solution to Problem 126 Chapter 13: Pricing Decisions13-35

13-36 Cost Management a) Using the general rule that the transfer price should equal the variable cost plus any opportunity cost results in a price of $15 per unit. Because the components division has plenty of capacity to meet demand, there is no market for additional units produced, and the transfer price would be the variable cost plus the opportunity cost of zero. b) Using the general rule that the transfer price should be equal to the variable cost plus any opportunity cost results in a price at $28 per unit because now the opportunity cost is the contribution margin foregone by selling the unit internally. So, the transfer price is variable cost plus contribution margin = market price. c) Transfer price questions 1. Norex and components division contribution margin = $13 x 100,000 = $1,300,000. 2. Norex contribution margin = $17 x 50,000 + $13 x 50,000 = $850,000 + $650,000 = $1,500,000. Components division CM = $13 x 50,000 + 0 = $650,000. 3. Managers of the components division will not be willing to sell internally at variable cost, when they can get market price if all units are sold externally. 4. The opportunity cost is $200,000 ($1,500,000 - $1,300,000) 5. The dual rate method would be best, so that seller is credited for the market price (its opportunity cost) and buyer is charged the variable cost. In this problem, market price or negotiated prices would also work, so students may give this response. 127) Following is information for the Krishnan Company’s three business divisions: Division A Division B Division C Pretax operating income $800,000 $400,000 $600,000 Current assets 80,000 60,000 80,000 Long-term assets 3,200,000 2,600,000 1,600,000 Current liabilities 400,000 200,000 300,000 Krishnan’s tax rate for the divisions is 30%, and its after-tax weighted-average cost of capital (WACC) for each segment is 12%. The WACC is also used as a required rate of return. a) Determine the division with the highest ROI. Show your calculations. b) Determine the division with the highest residual income. Show your calculations. c) Determine the segment with the highest EVA. Show your calculations. d) Compare and contrast these three performance measures and their influence on managers. e) Why is it better to use multiple measures for evaluating manager performance rather than a single measure such as ROI or EVA? Solution to Problem 127 a) ROI: Division C is highest Division A = $800,000/$3,280,000 = 24% Division B = $400,000/$2,660,000 = 15% Division C = $600,000/$1,680,000 = 36% b) RI: Division A is highest

Division A = $800,000 – (12% x $3,280,000) = $406,400. Division B = $400,000 – (12% x $2,660,000) = $80,800 Division C = $600,000 – (12% x $1,680,000) = $398,400 c) EVA: Division C is highest Division A = (70% x $800,000) – (12% x $2,880,000) = $214,400 Division B = (70% x $400,000) – (12% x 2,460,000) = $(15,200) Division C = (70% x $600,000) – (12% x $1,380,000) = $254,400 d) RI and EVA provide information about the dollar amount of return, whereas ROI is a percentage. RI and EVA incorporate a required rate of return, while ROI does not. ROI can easily be compared among divisions, whereas RI and EVA are not easily compared because size has an influence. ROI is subject to greater accounting manipulation than the other two methods. EVA allows development of a measure that is less subject to manipulation and results in more optimal decision-making. e) No one single measure can capture all aspects of a manager’s performance, and all measures have both strengths and weaknesses. Multiple measures also reduce the likelihood that managers will focus on too narrow an aspect of operations. Chapter 13: Pricing Decisions13-37