Cost Data For Managerial Purposes

Cost Data For Managerial Purpose

Scenario T-Rex Company makes a variety of products. It is organized in two divisions, East and West. The managers for each division are paid, in part, based on the financial performance of their divisions. The West Division normally sells to outside customers but, on occasion, also sells to the East Division. When it does, corporate policy states that the price must be cost plus 15 percent to ensure a “fair” return to the selling division.

West received an order from East for 600 units. West’s planned output for the year had been 2,640 units before East’s order. West’s capacity is 3,300 units per year. The costs for producing those 2,640 units follow: Production Costs for 2,640 Units TOTAL PER UNIT Materials $ 528,000.00 $ 200.00 Direct Labor Cost $ 253,440.00 $ 96.00 Other Costs Varying with Output $ 168,960.00 $ 64.00 Fixed Costs (do not vary with output) $ 2,217,600.00 $ 840.00 Total Costs $ 3,168,000.00 $ 1,200.00

This problem demonstrates the ambiguity in measuring “costs.” West Division’s controller included the “per unit” fixed costs, which were calculated for allocation purposes under normal production volume, when he or she calculated the per unit cost of the additional production. The controller charged East Division on that basis, ignoring the differential costs as a basis for interdivision sales. Possible options available are as follows: A. Use the full per unit cost for normal production of 2,640 units. B. Use only differential costs as the cost basis. C. Use differential costs plus a share of fixed costs, based on actual production volume (with East’s order) of 3,300 units. Costs A B C Direct materials (variable) Direct labor (variable) Other variable costs Fixed costs Per unit cost Cost plus 15% Total price (600 units)

REQUIRED:

• a. If you are the manager of the West Division, what unit cost would you ask the East Division to pay? Show calculations.
• b. If you are the manager of the East Division, what unit cost would you argue you should pay? Show calculations.
• c. What unit cost would you recommend for a sale of units from the West Division to the East Division? Explain briefly.

Paper For Above instruction

In analyzing the transfer pricing options between the West and East divisions of T-Rex Company, it is essential to understand the implications of cost measurement and how different costing approaches influence intra-company transactions. Transfer pricing is a critical managerial decision that affects divisional performance, tax considerations, and overall profitability. This paper examines three potential cost bases—full absorption costing, variable or differential costs, and a hybrid approach—and evaluates what each division might argue for in terms of price. The relevance and appropriateness of each method depend on managerial objectives, cost allocation mechanics, and strategic considerations.

Full Cost (Absorption Cost) Approach

Using the full per-unit cost, calculated on the normal production volume of 2,640 units, results in a per-unit cost of $1,200 ($3,168,000 total costs/2,640 units). This approach allocates both variable and fixed costs uniformly, regardless of the incremental nature of the order from East. From the perspective of the West Division manager, this approach might seem fair because it reflects the total costs invested in production. However, it disregards the marginal costs relevant to the specific transaction, potentially leading to pricing that does not cover variable costs or contribute to fixed costs, particularly in a short-term scenario. The total price for 600 units, incorporating a 15% markup, would be calculated as: $1,200 + (15% × $1,200) = $1,380 per unit, or $828,000 for 600 units.

Variable or Differential Cost Approach

In contrast, the differential or variable costs focus solely on the costs that change with the production of additional units. These costs include direct materials ($200/unit), direct labor ($96/unit), and other variable costs ($64/unit), totaling $360 per unit. This approach ensures that the transfer price at least covers the incremental costs incurred, avoiding losses on additional units and promoting efficiency. The total cost for 600 units, with a 15% markup, becomes: ($200 + $96 + $64) = $360 + 15% = $414 per unit, totaling $248,400. This approach is favored by East division managers as it minimizes costs and aligns with short-term decision-making.

Hybrid Approach: Differential Costs Plus Fixed Cost Share

The third method considers differential costs ($360 per unit) plus a proportionate share of fixed costs, based on actual production volume of 3,300 units. Fixed costs allocated per unit are $2,217,600 / 3,300 units ≈ $672 per unit, which is high and might distort decisions. Including fixed costs apportions the cost burden more fairly over total capacity, but may overstate the actual incremental costs associated with the extra units. Calculating the total for 600 units with this approach involves adding variable costs ($360), fixed costs per unit ($672), and the 15% markup, leading to a substantially higher transfer price that could discourage intra-company transfer or inflate costs unnecessarily.

Analysis for Managerial Decision-Making

If I were the West Division manager, I would advocate for a transfer price based on differential costs ($360 per unit) plus a contribution toward fixed costs that reflect the incremental capacity utilization. This approach ensures that West recovers variable costs and contributes to fixed expenses, creating incentives for cost control and efficiency. From the East Division perspective, arguing for a price grounded at or near variable costs aligns with minimized expenses and maximizes profit margins.

Considering these approaches, the most appropriate transfer price balances economic efficiency, fair cost recovery, and managerial incentives. The differential cost approach, with potential adjustments for fixed costs, often provides the best middle ground. It encourages responsible decision-making without distorting incentives or causing conflict between divisions. Therefore, I recommend a transfer price based primarily on variable costs, adding an equitable share of fixed costs if necessary, with a markup aligned with fair market principles.

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