Question

Part II: Transfer Pricing
Pacific Northwest Lumber has two divisions: Raw Lumber and Finished Lumber. The variable
costs incurred in each division are as follows:
Raw Lumber: VC $15 per 20 feet of raw lumber
Finished Lumber: VC $15 per 20 feet of finished lumber
Assume that footage of lumber is not lost when raw lumber is processed to finished lumber.
Market prices for the products are:
$35 for 20 feet of raw lumber
$55 for 20 feet of finished lumber
Required.
a. Compare the unit contribution margin of raw lumber relative and finished lumber for the
firm.
b. Assume internal transfers from the Raw Lumber Division to the Finished Lumber Division
are made at 120% of variable costs. Will the Division Manager of Raw Lumber prefer to
sell raw lumber externally or transfer to the Finished Lumber Division? What does the
division manager of Finished Lumber prefer? Assume both division managers are
compensated based on the profitability of their division and, thus, want to maximize their
respective division’s net income.
c. Assume, instead, that transfers from the Raw Lumber Division to the Finished Lumber
Division are made at market prices. Will the Raw Lumber division prefer to sell externally
or internally? What will the Finished Lumber division prefer?

Answer 1

Answer a

	Raw Lumber	Finished Lumber
Selling Price	35.00	55.00
Variable Cost	15.00	15.00
Cost of Raw Lumber	-	15.00
Contribution Margin for the firm	20.00	25.00

Answer b

Transfer price of Raw Lumber = 120% of Variable Cost = 120% of $15 = $18

Since the Raw Lumber division can sell raw lumber outside at $35, the manager of Raw Lumber division will prefer to sell the goods to external market instead of internal transer to Finished Lumber division @ $18 per unit.

Division manager can either take raw lumber from raw lumber division at $ 18 or can purchase from outside market at $35. Since it is cheaper when raw lumber is internally transferred, division manager fof finished lumber would prefer to take raw lumber from raw lumber division at $18

Answer c

Transfer price of Raw Lumber = Market Price = $35

Raw Lumber division will be indifferent between selling the goods internally and selling it externally because under both the alternative selling price is $35 (market price)

Similarly, Finished Lumber division will also be indifferent between purchasing the goods internally or externally because under both the alternative purchase price is $35 (market price)