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Department
Politics and Public Administration
Course
POG 210
Professor
Margaret Buckby
Semester
Fall

Description
Chapter 13: Pricing Decision65 Chapter 13 Pricing Decisions LEARNING OBJECTIVES Chapter 13 addresses the following objectives: LO1 Compare the different pricing methods and calculate prices using each method. LO2 Discuss other market-based sources of pricing information. LO3 Explain the uses and limitations of cost-based and market-based pricing. LO4 Explain price elasticity of demand and its impact on pricing. LO5 Discuss the additional factors that affect price. LO6 Compare the different pricing methods used for transferring goods and services within an organization. LO7 Discuss the uses and limitations of different transfer pricing methods. LO8 Discuss additional factors that affect transfer prices. These learning objectives (LO1 through LO8) are cross-referenced in the textbook to individual exercises and problems. © 2012 John Wiley and Sons Canada, Ltd. 66 Cost Management QUESTIONS 13.1 Factors to be considered when determining the selling price of a product include: cost, competition, and customers. Cost-based prices are determined by adding a mark-up to some calculation of the product’s cost. The cost base can be calculated in several ways such as variable costing absorption costing, or total costing. Market-based prices are determined using some measure of customer demand. Managers strive to identify what customers are willing to pay for the good or service. Market prices are affected by product differentiation and the degree of competition. The price elasticity of demand is another factor of pricing that must be considered. As prices change demand and the volume of sales will change, affecting the profit that will be realized from the price. 13.2 Cost-based pricing is performed by adding a mark-up to some measure of product cost, such as variable costs or a partially or fully allocated cost. For example, if a computer’s variable costs were $300 and the required mark-up 100%, the price would be $600 ($300 + 100%*$300). 13.3 Market based prices are determined using some measure of customer demand. Managers identify the amount that customers are willing to pay for a good or service and set the price at that amount. With historical information about prices and quantities sold, the price elasticity of demand formula can be used to determine a profit-maximizing price. Market research could be conducted and competitors’ prices could be analyzed. The Internet is also a source for pricing information. 13.4 This problem is called the death spiral because as demand falls, average costs increase because fewer units are produced. This means that price will increase because it is based on average cost. When price increases, demand usually falls, so production will also fall, and average cost will increase, causing prices to increase, causing demand to fall, and finally the company goes out of business. 13.5 Calculation of a mark-up percentage using variable costing as the cost base starts with determining the desired return on investment plus fixed costs. This amount is then divided by the variable cost per unit times the annual volume to determine the mark-up percentage. Calculation of a mark-up percentage using absorption costing as the cost base starts with the desired return on investment plus selling and administrative costs. This amount is then divided by the absorption cost per unit times the annual volume. The difference in these two formulas is that under absorption costing the fixed costs of both production, selling, and administration are all included in the absorption cost per unit and therefore are not used in the numerator value. 13.6 Not-for-profit organizations often receive donations and grants to help off-set operating costs. Therefore they do not have to set prices so that their operating costs are recovered. They have other organizational objectives, such as providing services to low-income people. Hence they may set prices using a sliding scale according to ability to pay. They may not charge for some products or services. © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 67 13.7 The componentsof a time and materials bill are a labour rate and a materials loading charge, respectively. The labour rate includes 1) direct labour salaries plus benefits, 2) selling and administrative costs and related overhead costs, and 3) a desired profit amount. The materials loading charge includes 1) all costs associated with purchasing, receiving, handling, and storing materials; and 2) a desired profit percentage. 13.8 From the overall organization’s point of view, it does not matter which branch pays for shipping. However, if each branch is held responsible for their own costs, each would prefer to have the other one pay for shipping charges because costs in the paying branch will be increased. 13.9 Advantages of decentralization for this company: Because expansion is into other countries, decision making will be timelier and probably more appropriate because local managers understand the local markets. The need to communicate detailed information up and down the organization will be reduced. The people making the decisions have the most knowledge and expertise. Disadvantages: The decision makers may have objectives that are different from the overall company’s objectives. Decisions need to be coordinated among all of the divisions to reduce non-optimal behaviour such as duplication of products or services. Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker. 13.10 A suboptimal decision is one in which the overall organization does not receive as high a contribution as is possible. If it is cheaper to produce the product or service internally, but the transfer price is set so that the incentive is to purchase externally, more is being paid for the good or service than should be, and a suboptimal decision has been made. 13.11 Transfer prices can be set based on cost (variable, variable plus some fixed costs, or variable and a fully allocated fixed cost), or based on market price for the good or service (and there may be a variety of ways to estimate the market price). Alternatively, transfer prices can be negotiated between two divisions. The seller could receive market price and the buyer could receive variable cost under a dual-rate method. Lastly, an organization could decide not to charge for transfers. 13.12 Income tax regulations are often concerned with ensuring the adequacy of taxes paid to the local country for international transactions. The CRA in Canada requires arm’s length transfer prices (market prices). This limits the kinds of transfer prices that can be set for income tax accounting. However, companies do not necessarily use the same transfer prices for income taxes and for other purposes such as internal performance measurement. 13.13 For organizations that do business internationally, the taxable location of profit is affected by transfer price policies. To restrict firms’ ability to shift income from a high- tax to a low-tax country the Canadian government enacted legislation to regulate transfer prices. © 2012 John Wiley and Sons Canada, Ltd. 68 Cost Management MULTIPLE-CHOICE QUESTIONS 13.14 WWL Ltd. has a target before-tax profit of $200,000. At the planned sales volume for each of its products, the variable and fixed costs are $2,000,000 and $400,000, respectively. All fixed costs are common to all products. If the selling price of one of the products is $13 per unit, and the unit has allocated to it fixed costs of $2 per unit, what is the target variable cost (to the nearest cent) to make its average mark-up over full costs? a ) $9.00 b) $9.80 c) $10.00 d) $10.15 Ans: C Markup on total costs. OC $200,000 + FC400,000 = CM $600,000 CM $600,000 + VC $2,000,000 = Sales $2,600,000 Sales/ total costs = markup; $2,600,000 / ($400,000 + $2,000,000) = 1.0833 Product USP $13 = 1.08333 * (VC + FC) $13 = 1.08333 * (VC + $2.00) $13 = 1.08333VC + $2.1666 $13 - $2.1666 = 1.08333VC VC = $10.8334/1.08333 = 10.0001 13.15 Clay Cookery produces ceramic cookware. Variable costs include clay and glazes for each crock andselling expenses. Fixed costs include salaries for potters and the necessary equipment to producethe cookware. There are also fixed marketing and administrative costs. Clay Cookery’s owner has$80,000 invested in the business and desires an 8% return on his investment. Clay Cookery sells3,650 crocks per year. Product Costs Variable $4.50 per crock Fixed $78,000 per year Selling, Marketing and Administrative Costs Variable $3.00 per crock Fixed $15,000 per year Using the absorption approach to cost-based pricing, what are the mark-up percentage and the selling price? Mark-up percentage Selling price a) 5.32% $34.73 b) 34.26% $34.73 c) 27.48% $32.98 d) 363% $34.73 ($80,000 * .08) + $15,000 + ($3.00 * 3,650) Ans: B $78,000 + ($4.50 * 3,650) = 34.26% $25.87 *(1+0.3426) = $34.73 © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 69 13.16 Based on the information in multiple choiceproblem 13.15, calculate the mark-up percentageand selling price assuming that Clay Cookery usesvariable cost-based pricing. Mark-up percentage Selling price a) 5.32% $34.73 b) 34.26% $34.73 c) 27.48% $32.98 d) 363% $34.73 Ans: D. ($80000 * .08) + $78000 + $15000 ($4.50 + $3.00) * 3650 =3.63 = 363% $7.50 *(1+3.63) = $34.73 13.17 Road Runners is a bike sales and service shop. The service division uses a time and material billingpolicy. Based on the following costs and desiredprofits, calculate the hourly rate for labour and thematerial loading charge for Road Runners assumingthat the service technicians work 2,960 hours peryear and invoice costs total $ 64,000 per year.Round to two decimal places. Labour Materials Technicians’ salaries $74,000 Office supplies $3,000 $8,000 Parts $24,000 Overhead on equipment $5,000 Advertising costs $3,000 Desired profit $7 per hour 15% Hourly labour rate Materials loading charge a) $28.72 15% b) $28.72 50% c) $35.72 65% d) $35.72 50% Ans: C Total labour cost = $74,000 + $3,000 + $5,000 + $3,000 = $85,000 $85,000/ 2,960 hrs = $28.72 labour cost per hour $28.72 cost per hour + $7 profit per hour = $35.72 total hourly rate for labour [($8,000 + $24,000) / $64,000 per year]+ 15% profit= 0.5 + 0.15 = 65% © 2012 John Wiley and Sons Canada, Ltd. 70 Cost Management 13.18 Ruce Ltd. has two manufacturing divisions, located in the same plant. Division X is evaluated as a cost centre and Division Y is evaluated as a profit centre. Division X produces component X98 at a budgeted full cost of $108 per unit, of which $100 represents variable costs. Currently, Division X is operating at full capacity and transfers all of its output to the sales division at $108 per unit. The sales division sells component X98 to external customers for $133 per unit; it incurs variable costs of $9 per unit to sell the component. Division Y purchases a component similar to X98 from an outside supplier for $125/unit plus a $2 per unit delivery charge. Ruce Ltd.’s production engineers have determined that component X98 could be used by Division Y with no adverse effects on the quality of the final product. Assume that no selling or delivery expenses would be incurred for internal transfers. What is the highest transfer price per unit that Division Y should be willing to accept for component X98? a) $133 b) $124 c) $125 d) $108 e) $127 Ans: E Division Y current cost is $125 + $2 = $127 so that is the highest they would pay. © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 71 EXERCISES 13.19 Cost-Based Pricing – Designs by Breanne A. Determine the mark-up percentage using 1. Absorption cost-based pricing Mark-up percentage = Desired return on investment + Selling and administrative costs Absorption cost per unit * Annual volume ($65,000 *0.12) + [$50,000 + ($45 * 3,000)] + $2,500 + ($15 * 3,000) = 58.04% $39,000 + ($125 * 3,000) 2. Variable cost-based pricing Mark-up percentage = Desired return on investment + Fixed costs Variable cost per unit * Annual volume ($65,000 *0.12) + $50,000 + $39,000 + $2,500 = ($45 + $125 + $15) * 3,000 $7,800 + $50,000 + $39,000 $99,300 + $2,500 = = 0.1789 = 17.89% $185 * 3,000 $555,00 0 3. Total cost-based pricing Mark-up percentage = Desired return on investment Total cost per unit * Annual volume $65,000 *0.12 $50,000 + $39,000 + $2,500 + ($185 * = 3,000) $7,800 $646,50 = 0.0121 = 1.21% 0 © 2012 John Wiley and Sons Canada, Ltd. 72 Cost Management B. Determine the selling price for each mark-up percentage calculated in Part A. Absorption cost-based pricing Selling price = Absorption costs + (Absorption costs * Mark-up %) [$125 + ($39,000 / 3,000)] *(1 + 0.5804) = $218.10 Variable cost-based pricing Selling price = Variable costs + (Variable costs * Mark-up %) $185 *(1 + 0.1789) = $218.10 Total cost-based pricing Selling price = Total costs + (Total costs * Mark-up %) [$185 + ($91,500/3,000)] *(1 + 0.0121) = $218.11 Differences in the above calculations are due to rounding C. Discuss the other factors that Breanne must consider when setting her selling prices: • Customers: demand, price sensitivity, expectations • Competition: existence & price 13.20 Cost-Based Pricing – Wagon Wheels A. Determine the mark-up percentage using 1. Absorption cost-based pricing Mark-up percentage = Desired return on investment + Selling and administrative costs Absorption cost per unit * Annual volume ($55,000 *0.15) + [$30,000 + $4,000 + $2,400 + ($3.50 * 7,200)] = $240,000 +$850 + [($1.50 + $45) * 7,200] $69,850 $575,650 = 0.1213 = 12.13% 2. Variable cost-based pricing Mark-up percentage = Desired return on investment + Fixed costs Variable cost per unit * Annual volume ($55,000 *0.15) + $240,000 + $30,000 + $4,000 + $2,400 + $850 ($45 + $3.50 + $1.50) * 7,200 = © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 73 $285,500 $360,000 = 0.7931 = 79.31% 3. Total cost-based pricing Mark-up percentage = Desired return on investment Total cost per unit * Annual volume ($55,000 *0.15) $8,250 = = 0.0129 = 1.29% $277,250 + ($50 × $637,350 7,200) B. Determine the selling price for each mark-up percentage calculated in Part 1. Absorption cost-based pricing Selling price = Absorption costs + (Absorption costs * Mark-up %) ($45 + $1.50 + ($850/7,200) + $240,000/7,200) * (1 + 0.1213) = $79.95 * 1.1213 = $89.65 Variable cost-based pricing Selling price = Variable costs + (Variable costs * Mark-up %) ($45 + $3.50 + $1.50) * (1 + 0.7031) $50 * 1.7931 = $89.66 Total cost-based pricing Selling price = Total costs + (Total costs * Mark-up %) [$50 + ($277,250/7,200)] * (1 + .0129) $88.51 * 1.0129 = $89.65 Differences in the above calculations are due to rounding C. Discuss the other factors that Wagon Wheels must consider when setting her selling prices. • Customers: demand, price sensitivity, expectations • Competition: existence & price 13.21 Time and Materials Pricing – Happy Homes A. Calculate the labour rate that Happy Homes uses Maids’ salaries $60,000 Office supplies 18,000 Overhead on equipment 5,000 Advertising costs 3,000 Total labour costs $86,000 © 2012 John Wiley and Sons Canada, Ltd. 74 Cost Management Labour cost / hour $86,000 / 4,000hours = $21.50 Desired profit 10.00 Labour rate $31.50 B. Calculate the materials loading charge for Happy Homes Office supplies $18,000 Supplies 24,000 Total material costs $42,000 Material costs $42,000 /$200,000 invoice costs= 0.21= 21% Profit margin 20% Materials loading charge 41% C. Cathy’s bi-weekly bill Labour 2 maids * 4 hours = 8 hours * $31.50 $252.00 Materials Flowers $55 *1.41 77.55 $329.55 13.22 Activity Based Costing and Price Setting – Dundas Company Direct materials $ 140 Machine set up ($180 * 3 /60) 9 Materials handling ($15 * 35) 525 Milling ($50 * 6) 300 Assembly ($30 * 4) 120 Manufacturing cost per unit $1,094 Price to achieve gross margin of 35% the price per unit should be= $1,094/0.65 = $1,683 (rounded). © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 75 13.23 Market-Based Price (Elasticity Formula) - Lickety Split Percent change in price = ($1.93 - $1.75)/$1.75 = +10% Percent change in demand = (1,000 – 850)/1,000 = –15% The elasticity is ln (1 + percent change in quantity sold)/ln(1+percent change in price) = ln(1–0.15)/ln(1+0.1) = –0.16252/0.09531 = –1.705 Variable cost = $640/1,000 = $0.64 Profit-maximizing price = [–1.705/(–1.705+1)]*$0.64 = $1.55 To maximize profits, the manager needs to lower the price rather than increase it. 13.24 Market-Based Prices (Elasticity Formula) - Paulo’s Flowers A. The elasticity is ln(1+0.35)/ln(1–0.20) = 0.30010/–0.22314 = –1.345 Mark-up = [–1.345/(–1.345+1)] – 1 = 2.899, or 2.9 Variable cost = $0.40 Price = (2.9 * $0.40) + 0.40 = $1.56 Or Price = [–1.345/(–1.345+1)] *$0.40 = $1.56 B. The elasticity is ln(1–0.12)/ln(1+0.10) = –0.12783/0.09531 = –1.341 Mark-up = [–1.341/(–1.341+1)] – 1 = 2.93 The formulas indicate that he should increase his current mark-up, to nearly 300%. However, these formulas are very sensitive to errors in the estimates of price and quantity changes, so they should be used only as guidelines. He can slowly begin increasing the mark-up until he reaches the point where contribution margin times quantity sold maximizes his profits. 13.25 Market-Based Price (Elasticity Formula), Uncertainties, Other Pricing Factors – La Cabane à Sucre A. Elasticity = ln(1+0.20)/ln(1-0.10) = 0.18232/–0.10536 = –1.730 © 2012 John Wiley and Sons Canada, Ltd. 76 Cost Management B. Variable cost = $2,400/1,500 = $1.60 Profit maximizing price = [–1.730/(–1.730+1)] * $1.60 = $3.79 C. She should drop the price, but in slow increments to determine the point at which the contribution margin * quantity sold maximizes profits. D. The following factors could affect her price decision: • Any constraints in the resources and capacity she has available • Competitor’s actions • General economic factors, if the economy is down, she may need to lower her price • Weather affects the number of customers and she may need to run sales during slow times to move inventory and ingredients that have a short shelf life. 13.26 Market-Based (Elasticity Formula) and Cost-Based Prices, Special Order Decision – Malpeque Bayview [Note: This problem requires knowledge of special order decisions (Chapter 4).] A. Elasticity = ln(1–0.15)/ln(1+0.10) = –0.16252/0.09531 = –1.705 Variable cost = $120,000/2,000 = $60 Profit maximizing price = [–1.705/(–1.705+1)]* $60 = $145 per case B. The minimum price for a special order decision is variable cost, so it is $60 for Malpeque Bayview. C. Linda must be sure that there are no constraints on the amount of oysters available at this time. She also needs to know whether there would be any increase in wages or fixed costs if she adds more capacity. She needs to know whether other customers might find out about this price and demand lower prices. Students may think of other relevant factors. 13.27 Transfer Prices – ED Electronics A. The part division is operating at full capacity and the minimum transfer price that the manager would be willing to accept is the market price of $75. B. The maximum transfer price should be $75. If the transfer price is more than $75, the manager would be better off buying the component from an external supplier. Moreover, © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 77 with a transfer price of $75 the incremental cost of each device would be $350, which is less than $425, the price offered by the wholesaler for each unit of the device. C. No, because the part division is operating at full capacity and it can sell part X22 at the current market price of $75 and, in that case, the bit division will have to buy part X22 on the market at the same price. The company should be indifferent between the two possibilities. D. If the part division is not operating at full capacity, it would be beneficial for the company to transfer at full cost. If the transfer is not taking place, then the part division would not be able to sell the 500 units on the market and the bit division would have to buy them from an external supplier at $75 per unit, which is greater than the full cost of $50 and even greater than the variable costs, which are the only relevant costs in this case. 13.28 Transfer Prices – Wood Inc. A. For the company as a whole: Contribution margin from selling 10,000 logs to external customers: [$75 – ($40.50 + $9.50)] × 10,000 = $250,000 Contribution margin from selling 10,000 units of Pole-S: [$122.00 – ($40.50 + $9.50) – ($35.00 + $4.50 + $2.50)] × 10,000 = $300,000 The contribution margin is $50,000 higher if logs are transferred from the Harvesting Division to theSawing Division. Wood Inc. would be better off transferring the logs. B. The transfer of logs at $61.50 will have the effect of transferring profits from the Harvesting Divisionto the Sawing Division. As the two divisions are evaluated as profit centres, the manager of theHarvesting Division will be penalized while the manager of the Sawing Division will benefit. C. The minimum transfer price is equal to the variable costs of the Harvesting Division, which is equal to$50. The maximum transfer price is equal to the market price of $75 per log. The market price of $75is the appropriate transfer price because the Harvesting division is operating at full capacity © 2012 John Wiley and Sons Canada, Ltd. 78 Cost Management 13.29 ROI, Transfer Prices, Taxes, Employee Motivation – Fowler Electronics A. ROI if the screens are transferred at variable cost: Windsor Detroit Revenue (10,000 x $2,500) $25,000,000 Variable production costs: (10,000 x $350) $(3,500,000) (10,000 x $110) (1,100,000) Fixed production costs (2,000,000) (4,000,000) Transfer price (10,000 x $350) 3,500,000 (3,500,000) Pre-tax income (loss) (2,000,000) 16,400,000 Income taxes (a) 0 (7,380,000) Net income (loss) $(2,000,000) $ 9,020,000 Total assets $20,000,000 $30,000,000 ROI (Net income / Investment) (10)% 30% (a) Income tax calculations: The Windsor plant has a loss. The problem provides no information about whether Canadian tax law allows companies to carry losses back against prior income or forward against future income. However, if the Windsor plant does not sell to outside customers, then it might always incur a loss if variable cost is used as the transfer price. Therefore, the income tax effect is estimated as zero. Tax for Detroit plant = $16,400,000 x 45% = $7,380,000 B. ROI if the screens are transferred at market price: Windsor Detroit Revenue (10,000 x $2,500) $25,000,000 Variable production costs: (10,000 x $350) $(3,500,000) (10,000 x $110) (1,100,000) Fixed production costs (2,000,000) (4,000,000) Transfer price (10,000 x $750) 7,500,000 (7,500,000) Pre-tax income (loss) 2,000,000 12,400,000 Income taxes (a) (600,000) (5,580,000) Net income (loss) $ 1,400,000 $ 6,820,000 Total assets $20,000,000 $30,000,000 ROI (Net income / Investment) 7% 23% © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 79 (a) Income tax calculations: Tax for Windsor plant: $2,000,000 x 30% = $600,000 Tax for Detroit plant = $12,400,000 x 45% = $5,580,000 C. The firm will prefer the market transfer price because it maximizes company income. Total income is increased through tax rate differences between Canada and the United States. In addition, if variable costs are used, then there is a tax loss in Canada for which no tax benefit is received. The net tax advantage of using market value for the transfer price is: Taxes if transfer price is the variable cost: Windsor $ 0 Detroit 7,380,000 Total $7,380,000 Taxes if transfer price is the market value: Windsor $ 600,000 Detroit 5,580,000 Total 6,180,000 Difference $1,200,000 D. The Windsor plant manager will prefer to transfer at the market price, and the Detroit plant manager will prefer variable cost because these transfer prices make their operations look best. E. Use of either the dual rate or the negotiation method would give managers the information they need to make the best decisions for the overall corporation. A problem with the dual rate method is that both plants appear to be more profitable than they really are. A problem with negotiating is that manager time can be tied up on activities that do not necessarily add value to the overall firm. 13.30 Choice of Transfer Price – Hand Held A. The contribution margin is $8 for the Cell Phone Division, so they will only be willing to pay what they pay now ($12) plus up to $8 more for $20, although they may not want to assemble the cell phones at break even. B. The transfer price that would be best for the company as a whole is $24, the market price. If market price is used for the transfer price, units will always be sold externally instead of internally. C. If the Chip Division has plenty of excess capacity, the transfer price should be the variable cost because the Chip Division could not sell the chips otherwise. © 2012 John Wiley and Sons Canada, Ltd. 80 Cost Management 13.31 Minimum Transfer Price, Capacity, Contribution Margins – Nexa’s A. At capacity, Division A will only sell at the market price of $200 B. If there is excess capacity, Division A has no demand for the units so the minimum transfer price would be Division A’s variable cost of $100 C. If there is excess capacity and Division B buys externally, the firm makes $80,000 less: 1,000 units × ($100 Division A variable cost – $180 for outside supplier) = $(80,000) D. If Division A is forced to sell to B when there is no excess capacity, the contribution margin is: 1,000 units × ($600 Division B selling price – $200 Division B variable cost – $100 Division A variable cost) = $300,000 E. If Division A is at capacity, Division A sells 1,000 units on the external market, and Division B purchases from an outside supplier, the contribution margin is: Division A contribution margin [($200-$100) × 1,000 units] $100,000 Division B contribution margin [($600-$200-$180) × 1,000 units] 220,000 Total contribution margin $320,000 F. The more profitable course of action depends on whether Division A is operating at capacity selling to outside customers. As calculated in Part C, the company is better off by $80,000 if Division A sells to Division B when there is excess capacity. If there is no excess capacity, the calculations in Parts D and E show that company is better off by $320,000 – $300,000 = $20,000 if Division A sells to outside customers and Division B purchases from an outside supplier. G. If there is no outside supplier for Division B, the best course of action depends on the companywide contribution margin per unit under each option: If units are sold by Division A: ($200 – $100) = $100 per unit If units are sold by Division B: ($600–$200–$100) = $300 per unit Because the companywide contribution margin per unit would be higher for units sold by Division B, the company would be better off for Division A to sell internally. 13.32 Transfer Price, Sale to Outside Versus Inside Customer – Carlyle Corporation There are several ways to solve this problem. Here is one approach: First, consider the per-unit differences in cost and revenue for the two options. Ajax’s variable cost per unit is $900,000 / 20,000 units = $45 VC per unit. If Ajax sells to © 2012 John Wiley and Sons Canada, Ltd. Chapter 13: Pricing Decisions 81 outsiders at $75 per unit, the contribution margin is $30 to Ajax, so its gross margin improves by $600,000 ($30 x 20,000 units). If Bradley replaces Ajax’s units with $85 units from an outside supplier, the total cost per unit to the company is $55 ($85 cost from outside vendor less the $30 contribution margin from Ajax’s outside customer). The variable cost of these units is $45 each, so Carlyle’s gross margin is maximized only by transferring the units internally at a savings of $10 per unit. Here is another approach: Notice that none of Ajax division’s costs will change if it accepts the new opportunity; the division will continue to operate at full capacity. The only change in its gross margin will be the difference in revenue: Revenue from new customer (20,000 x $75) $1,500,000 Current revenue from Bradley division 900,000 Increase in revenue $ 600,000 Based on the preceding calculation, the Ajax division will be better off if it accepts the new order. However, the company as a whole will not be better off. The company will receive outside revenue of $75 per unit and it will pay an outside supplier $85 per unit, for a net decrease in gross margin of $10 per unit. PROBLEMS 13.33 Cost-Based and Market-Ba
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