(Effect of alternative transfer-pricing methods on division operating income)

Leamington Ketchup Inc.is a company vertically integrated that produces and sells 20% of the ketchup consumed in Canada. It has three support departments (administrative, industrial relations and engineering) and three main divisions:

a.Greenhouseoperates 50 industrial two-level greenhouses to grow tomatoes.

b.Processing plantprocesses the tomatoes into ketchup and packages the ketchup.

c.Distributionmanages the outbound logistic to deliver the ketchup to central warehouses of fast food chains (50%) and supermarkets (50%). The ketchup to fast food restaurants is sold in 10 kg cans at $20 and the ketchup to supermarkets is sold in boxes of 20 bottles of 500 grams (half kilo) at $30 each box.

The Processing Division has a yield of 66 kilograms of ketchup from 100 kilograms of tomatoes provided by the Greenhouse Division. The Distribution Division has a 10% of spoilage (broken cans, boxes or bottles inside the boxes). Cost data for each division are as follows:

Greenhouse Division

Variable cost per kilogram of tomatoes

$0.10

Fixed costs per kilogram of tomatoes

$0.22

Processing Plant Division

Variable cost per kilogram of ketchup

$0.20

Fixed cost per kilogram of ketchup

$0.20

Distribution Division

Variable costs per 10 Kg can

$2.00

Fixed cost per 10 Kg can

$3.00

Variable cost per 20 bottles box

$4.93

Fixed costs per 20 bottles box

$2.93

Fixed costs per kilogram are based on the estimated quantity of tomatoes, ketchup, and cans/boxes to be produced and moved during one month.

Leamington Ketchup has chosen to process internally all tomatoes grown by its Greenhouse Division and to exclusively distribute the ketchup elaborated by its processing plant. Other ketchup manufacturers in the region purchase tomatoes from farmers at $35 cents per kilogram, also there are logistics companies that but at $1 the kilogram of ketchup processed in small plants and distribute it to restaurants and local stores.

Required

1.Compute the overall operating income to Leamington Ketchup of growing 100 kilograms of tomatoes, processing it into ketchup, and then selling it to supermarkets and fast food chains.

2.Compute the transfer prices that will be used for internal transfers (i) from the Greenhouse Division to the Processing Plant Division and (ii) from the Processing Plant Division to the Distribution Division under each of the following transfer-pricing methods:

a.300% of variable costs. Variable costs are the costs of the transferred-in product (if any) plus the division's own variable costs.

b.120% of full costs. Full costs are the costs of the transferred-in product (if any) plus the division's own variable and fixed costs.

c.Market price.

3.Leamington Ketchup rewards each division manager with a bonus, calculated as 10% of division operating income (if positive). What is the amount of the bonus that will be paid to each division manager under each of the three transfer-pricing methods in requirement 2? Which transfer-pricing method will each division manager prefer to use?