Transfer Pricing & Management Behavior

Redstone Industrial Resources Company (RIRC) has several divisions. However, only two divisions transfer products to other divisions. The Mining Division refines toldine, which is then transferred to the Metals Division. The toldine is processed into an alloy by the Metals Division, and the alloy is sold to customers at a price of $450 per unit. The Mining Division is currently required by RIRC to transfer its yearly output of 400,000 units of toldine to the Metals Division at total manufacturing cost plus 10 percent. Unlimited quantities of toldine can be purchased and sold on the open market at $270 per unit. While the Mining Division could sell all the toldine it produces at $270 per unit on the open market, it would incur a variable selling cost of $15 per unit.

Brain Jones, manager of the Mining Division, is unhappy with having to transfer the entire output of toldine to the Metals Division at 110 percent of cost. In a meeting with the management of RIRC, he said, "Why should my division be required to sell toldine to the Metals Division at less than market price? For the year just ended in May, Metals' contribution margin was over $57 million on sales of 400,000 units, while Mining's contribution was just over $15 million on the transfer of the same number of units. My division is subsidizing the profitability of the Metals Division. We should be allowed to charge the market price of toldine when transferring to the Metals Division."

The following table shows the detailed unit cost structure for both Mining and Metals divisions during the most recent year.

Mining Division Metals Division

Transfer price from Mining Division -------- $198
Direct Material $36 18
Direct Labor 48 60
Manufacturing overhead 96 75

Total cost per unit $180 $351

Manufacturing overhead cost in the Mining Division is 25% fixed and 75% variable
Manufacturing overhead cost in the Metals Division is 60% fixed and 40% variable

1. Explain why transfer prices based on total actual costs are not appropriate as the basis for divisional performance measurement.

2. Using the market price as the transfer price, determine the contribution margin for
both the Mining and Metals Divisions.

3. If RIRC were to institute the use of negotiated transfer prices and allowed
divisions to buy and sell on the open market, determine the price range for toldine that would be acceptable to both the Mining and the Metals Divisions. Explain your answer.

4. Use the general transfer-pricing rule to compute the lowest transfer price that would be acceptable to the Mining Division. Is your answer consistent with your conclusion in question 3.

5. Identify which one of the three transfer prices (cost-based, market-based, or negotiated) is most likely to elicit desirable management behavior at RIRC.

See attached file for full problem description.