Strategy; Strategic Performance Measurement; Transfer Pricing Ajax Consolidated has severa...

Strategy; Strategic Performance Measurement; Transfer Pricing Ajax Consolidated has several divisions; however, only two transfer products to other divisions. The mining division refines toldine, which it transfers to the metals division where toldine is processed into an alloy and is sold to customers for $150 per unit. Ajax currently requires the mining division to transfer its total annual output of 400,000 units of toldine to the metals division at total (actual) manufacturing cost plus 10 percent. Unlimited quantities of toldine can be purchased and sold on the open market at $90 per unit. The mining division could sell all the toldine it produces at $90 per unit on the open market, but it would incur a variable selling cost of $5 per unit.

Brian Jones, the mining division’s manager, is unhappy transferring the entire output of toldine to the metals division at 110 percent of cost. In a meeting with Ajax management, 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, the contribution margin on metals was more than $19 million on sales of 400,000 units while the mining division’s contribution was just over $5 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 for toldine when we transfer it to the metals division.”

The following is the detailed unit cost structure for both the mining and metals divisions for the fiscal year ended May 31, 2010:

* Manufacturing overhead in the mining division is 25 percent fixed and 75 percent variable.

† Manufacturing overhead in the metals division is 60 percent fixed and 40 percent variable.

Required

1. Explain whether transfer prices based on cost are appropriate as a divisional performance measure and why.

2. Using the market price as the transfer price, determine the contribution margin for both divisions for the year ended May 31, 2010.

3. If Ajax were to institute the use of negotiated transfer prices and allow divisions to buy and sell on the open market, determine the price range for toldine that both divisions would accept. Explain your answer.

4. Identify which of the three types of transfer prices—cost-based, market-based, or negotiated—is most likely to elicit desirable management behavior at Ajax and thus benefit overall operations. Explain your answer.