Chapter 22, Problem 8BP

a.

To determine

Ascertain the operating profit before tax for each division using the market transfer price of $135.

Explanation of Solution

Ascertain the operating profit before tax for each division using the market transfer price of $135 as follows:

	Entire Company	Frame Division	Works Division
Sales	$1,162,500	$742,500	$825,000
Variable Costs	651,000	396,000	660,000
Contribution Margin	$511,500	$346,500	$165,000
Fixed Costs	384,000	280,000	104,000
Operating Profit	$127,500	$66,500	$61,000

Table (1)

Calculate the sales of Frame Division.

$\begin{array}{c}\text{Sales=Number of units}\times \text{Market price}\\ \text{=5,500}\text{units}\times \text{\$135}\\ \text{=\$742,500}\end{array}$

Calculate the sales of Works Division.

$\begin{array}{c}\text{Sales=Number of units}\times \text{Market price}\\ \text{=3,000}\text{units}\times \text{\$275}\\ \text{=\$825,000}\end{array}$

Calculate the sales of Entire Company.

$\begin{array}{c}\text{Sales=}\left[\begin{array}{l}\left(\begin{array}{l}\text{Number of Frame division units}-\\ \text{Number of Works division units}\end{array}\right)\times \left(\begin{array}{l}\text{Market price of frame}\\ \text{division}\end{array}\right)+\\ \left(\begin{array}{l}\text{Number of units of Works division}\times \\ \text{Market price of Works division}\end{array}\right)\end{array}\right]\\ \text{=}\left(5,500-3,000\right)\times \left(135\right)+\left(3,000\times \text{\$275}\right)\\ \text{=\$1,162,500}\end{array}$

Calculate the variable cost of Frame Division.

$\begin{array}{c}\text{Variable cost=Number of units}\times \text{Variable cost per unit}\\ \text{=5,500}\text{units}\times \text{\$72}\\ \text{=\$396,000}\end{array}$

Calculate the variable cost of Works Division.

$\begin{array}{c}\text{Variable cost=Number of units}\times \left(\text{Transfer price+Variable cost}\right)\\ \text{=3,000}\text{units}\times \left(\text{\$135+\$85}\right)\\ \text{=\$660,000}\end{array}$

Calculate the variable cost of Entire Company.

$\begin{array}{c}\text{Variable cost=}\left[\left(\begin{array}{l}\text{Number of Frame division units}\times \\ \text{Variable cost of Frame division}\end{array}\right)+\left(\begin{array}{l}\text{Number of Works division units}\times \\ \text{Variable cost of Works division}\end{array}\right)\right]\\ =\left(5,500\times \$72\right)+\left(3,000\times \text{\$85}\right)\\ \text{=\$651,000}\end{array}$

b.

To determine

Ascertain the operating profit before tax for each division using the transfer price of $130, as suggested by the manager of the Works Division.

Explanation of Solution

Ascertain the operating profit before tax for each division using the transfer price of $130, as suggested by the manager of the Works Division as follows:

	Entire Company	Frame Division	Works Division
Sales	$1,162,500	$727,500	$825,000
Variable Costs	651,000	396,000	645,000
Contribution Margin	$511,500	$331,500	$180,000
Fixed Costs	384,000	280,000	104,000
Operating Profit	$127,500	$51,500	$76,000

Table (2)

Calculate the sales of Frame Division.

$\begin{array}{c}\text{Sales cost=}\left[\left(\begin{array}{l}\text{Number of Frame division units transferred}\times \\ \text{Transfer price}\end{array}\right)+\left(\begin{array}{l}\text{Number of units sold}\\ \text{ to market}\times \\ \text{Market price}\end{array}\right)\right]\\ =\left(2,500\times \$135\right)+\left(\text{3,000}\times \text{\$130}\right)\\ \text{=\$727,500}\end{array}$

Calculate the sales of Works Division.

$\begin{array}{c}\text{Sales=Number of units}\times \text{Market price}\\ \text{=3,000}\text{units}\times \text{\$275}\\ \text{=\$825,000}\end{array}$

Calculate the sales of Entire Company.

$\begin{array}{c}\text{Sales=Sales of Frame division+Sales of Works division}\\ \text{=}\$727,500+\$825,000\\ \text{=\$1,162,500}\end{array}$

Calculate the variable cost of Frame Division.

$\begin{array}{c}\text{Variable cost=Number of units}\times \text{Variable cost per unit}\\ \text{=5,500}\text{units}\times \text{\$72}\\ \text{=\$396,000}\end{array}$

Calculate the variable cost of Works Division.

$\begin{array}{c}\text{Variable cost=Number of units}\times \left(\text{Negotiated transfer price+Variable cost}\right)\\ \text{=3,000}\text{units}\times \left(\text{\$130+\$85}\right)\\ \text{=\$645,000}\end{array}$

c.

To determine

Discuss the manner in which the company’s net income affected under the two transfer pricing scenarios.

Explanation of Solution

Discuss the manner in which the company’s net income affected under the two transfer pricing scenarios as follows:

Accounting entries that show the flow of goods between the departments are generated by the transfer prices. One department records the transfer price as revenue while on the other hand; the same is treated as an expense by the other department. These entries of revenue and expense are cancelled out for the entire company and hence, internal transfer prices do not have a direct effect on the net income of the company.

d.

To determine

Discuss whether it would be more beneficial to the company if the Frame Division sold casings externally and the Works Division purchased casings from an outside supplier.

Explanation of Solution

Calculate the pre-tax operating profit, using the external sale price and purchase price for the casings as follows:

	Entire Company	Frame Division	Works Division
Sales	$1,567,500	$742,500	$825,000
Variable Costs	1,071,000	396,000	675,000
Contribution Margin	$496,500	$346,500	$150,000
Fixed Costs	384,000	280,000	104,000
Operating Profit	$112,500	$66,500	$46,000

Table (3)

Calculate the sales of Frame Division.

$\begin{array}{c}\text{Sales=Number of units}\times \text{Market price}\\ \text{=5,500}\text{units}\times \text{\$135}\\ \text{=\$742,500}\end{array}$

Calculate the sales of Works Division.

$\begin{array}{c}\text{Sales=Number of units}\times \text{Market price}\\ \text{=3,000}\text{units}\times \text{\$275}\\ \text{=\$825,000}\end{array}$

Calculate the sales of Entire Company.

$\begin{array}{c}\text{Sales=Sales of Frame division+Salesof Works division}\\ \text{=\$742,500+\$825,000}\\ \text{=\$1,567,500}\end{array}$

Calculate the variable cost of Frame Division.

$\begin{array}{c}\text{Variable cost=Number of units}\times \text{Variable cost per unit}\\ \text{=5,500}\text{units}\times \text{\$72}\\ \text{=\$396,000}\end{array}$

Calculate the variable cost of Works Division.

$\begin{array}{c}\text{Variable cost=Number of units}\times \left(\text{Transfer price+Variable cost}\right)\\ \text{=3,000}\text{units}\times \left(\text{\$140+\$85}\right)\\ \text{=\$675,000}\end{array}$

Calculate the variable cost of Entire Company.

$\begin{array}{c}\text{Variable cost=}\left(\begin{array}{l}\text{Variable cost of Frame division+}\\ \text{Variable cost of Works division}\end{array}\right)\\ =\$396,000+\$675,000\\ \text{=\$1,071,000}\end{array}$

The company earns $15,000 more in operating profit if the Works Division purchases the casings from the Frame Division and hence, as a whole it is more beneficial to the company.