Marlys Consolidated has several divisions, two of which transfer their products to other divisions. The Mining division refines toldine, which it then transfers to the Metals division. The Metals division processes the toldine into an alloy and sells it to customers at a price of $170 per barrel. Marlys currently requires the Mining division to transfer its total annual output of 400,000 barrels of toldine to the Metals division at total manufacturing cost plus 10%. Unlimited quantities of toldine can be purchased and sold on the open market at $92 per barrel. While the Mining division could sell all the toldine it produces on the open market at $92 per barrel, it would incur a variable selling cost of $6 per unit to do so.

Barker Jonas, manager of the Mining division, is unhappy with having to transfer the division’s entire output of toldine to the Metals division at 110% of cost. In a meeting with the management of Marlys, he protested, “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 $16 million on sales of 400,000 barrels, while Mining’s contribution on the transfer of the same number of units was just over $6 million. My division is subsidizing the profitability of the Metals division. We should be allowed to charge market price for toldine when we transfer it to the Metals division.”

Detailed unit costs for both the Mining and Metals divisions follow.

Manufacturing overhead cost in the Mining division is 25% fixed and 75% variable. In the Metals division, it is 55% fixed and 45% variable.

Required

a. Explain why cost-based transfer prices are not appropriate as a divisional performance measure.

b. Using the market price as the transfer price, determine the contribution margins for both divisions for the last fiscal year.

c. If Marlys Consolidated were to institute negotiated transfer prices and allow divisions to buy and sell on the open market, what price range for toldine would be acceptable to both divisions? Explain your answer.

d. Which of the three types of transfer price—cost-based, market-based, or negotiated—is most likely to elicit desirable managerial behavior at Marlys Consolidated and thus benefit overall operations? Explain your answer.

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Mining Division Metals Division $ 77 Transfer price from Mining division Direct material $15 6 Direct labor 20 20 Manufacturing overhead 35 25 Total cost per barrel $70 $128