Joint Costs & Transfer Pricing

Cotopaxi makes backpacks. Traditionally, they bought fabric in quantity, and cut out the forms for their backpacks from large pieces, discarding the interstitial material as scrap. Due to the integrated nature of the production facility, the cost of all this fabric was considered a joint cost, allocated by the approximate relative sales value method, and the scraps were considered a waste by-product.

Recently, however, an enterprising employee had the great idea to use these scraps and make small, unique bags from the heretofore-discarded pieces of fabric. The company agreed to implement this idea on a trial basis, and the accounting department decided to consider these bags a by-product using the net realizable value method.

The marketing department set the price for the by-product bags at $50, and in the first year of production, 10,000 of these scrap bags were sold. At the end of the first year, the accounting department determined that each bag incurred an additional processing cost of $40 on average in additional materials (straps, buckles, thread, etc.), labor, and variable overhead (not including the cost of the scrap fabric from whence they came).

1. How much additional income does selling the by-product bags earn Cotopaxi (per bag)?

a: -$40 per bag (loss)

b: $0 per bag

c: $10 per bag

d: $40 per bag

e: $50 per bag

2. After the first year, Cotopaxi realized that the demand for the by-product bags is so great that they cannot supply enough for both the direct market sales and as bundled products. What is the optimal transfer price that the by-product bag division should charge given this capacity constraint?

a:$0 per bag

b: $10 per bag

c: $40 per bag

d: $50 per bag

3. What is the amount of Joint Cost, under the Net Realizable Value method, that will be allocated to each by-product bag?

a: -$40 of Joint Cost per bag

b: $0 of Joint Cost per bag

c: $10 of Joint Cost per bag

d: $40 of Joint Cost per bag

e: $50 of Joint Cost per bag

4. Given your answers to the two previous questions, and recalling that Cotopaxi usesthe net realizable value method to account for the by-product bags, how much profit per bag will be recognizedbythe by-product bagdivision?

a: -$40 per bag (loss)

b: $0 per bag

c: $10 per bag

d: $40 per bag

e: $50 per bag

5. What happened to the joint cost of fabric allocated to the main product lines when the new by-product bags were introduced?

a: Increased the joint costs allocated to the other products

b: Decreased the joint costs allocated to the other products

c: No change in joint costs allocated to the other products

6. What did this new line of by-product bags do to the recognized profitability of Cotopaxi's main backpack products?

a: Increased the profitability of the main products

b: Decreased the profitability of the main products

c: No change in the profitability of the main products

7. What did this new line of by-product bags do to the total profitability of Cotopaxi's as a whole? (Note: assume the new bags only incurred the variable costs listed above)

a: Increased overall profitability

b: Decreased overall profitability

c: No change to overall profitability

8. If Cotopaxi had instead allocated the joint-cost of fabric using the physical units method, how would this affect their overall profitability for the company as a whole (compared to allocating by the approximate relative sales value method)? (Note: assume all produced products were sold)

a: Increase profitability

b: Decrease profitability

c: No effect on profitability

9. If Cotopaxi had instead accounted for the new bags as a full product instead of a by-product, how would this affect their overall profitability for the company as a whole (compared to considering the new bags a by-product)? (Note: assume all produced products were sold)

a: Increase profitability

b: Decrease profitability

c: No effect on profitability