ACCT210 Study Guide Test 2
ACCT210 Study Guide Test 2 ACCT210
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Date Created: 03/23/16
ACCT210: Study Guide Test #2 Accounting 210: Chapter 6 Notes Cost Volume Profit Analysis: Additional Issues - CVP Analysis is: o The study of the effects of changes in costs and volume on a company’s profit. o Important to profit planning. o Critical in management decisions such as: ▯ Determining product mix, ▯ Maximizing use of production facilities, ▯ Setting selling prices. - Basic Concepts: o Management often wants the information reported in a special format income statement. o CVP income statement is for internal use only: ▯ Costs and expenses classified as fixed or variable. ▯ Reports contribution margin as a total amount and on a per unit basis. - Break Even Analysis: o Illustration: Vargo Video’s CVP income statement (Ill. 6-2) shows that total contribution margin is $320,000, and the company’s contribution margin per unit is $200. Contribution margin can also be expressed in the form of the contribution margin ratio which in the case of Vargo is 40% ($200 ÷ $500). - Target Net Income: o Once a company achieves break-even sales, a sales goal can be set that will result in a target net income. Illustration: Assuming Vargo’s target net income is $250,000, required sales in units and dollars to achieve this are: o Illustration: The contribution margin ratio is used to compute required sales in dollars. - Margin of Safety: o Tells us how far sales can drop before the company will operate at a loss. o Can be expressed in dollars or as a ratio. Illustration: Assume Vargo’s sales are $800,000: - CVP and Changes in the Business Environment: o Case I: A competitor is offering a 10% discount on the selling price of its camcorders. Management must decide whether to offer a similar discount. o Question: What effect will a 10% discount on selling price ($500 x 10% = $50) have on the breakeven point? o Case II: Management invests in new robotic equipment that will lower the amount of direct labor required to make camcorders. Estimates are that total fixed costs will increase 30% and that variable cost per unit will decrease 30%. o Question: What effect will the new equipment have on the sales volume required to break even? o Case III: Vargo’s principal supplier of raw materials has just announced a price increase. The higher cost is expected to increase the variable cost of camcorders by $25 per unit. Management decides to hold the line on the selling price of the camcorders. It plans a cost-cutting program that will save $17,500 in fixed costs per month. Vargo is currently realizing monthly net income of $80,000 on sales of 1,400 camcorders. o Question: What increase in units sold will be needed to maintain the same level of net income? - Question: Croc Catchers calculates its contribution margin to be less than zero. Which statement is true? o A .Its fixed costs are less than the variable cost per unit. o B. Its profits are greater than its total costs. o C .The company should sell more units. o D. Its selling price is less than its variable costs. - Break Even Sales in Units: o Sales mix is the relative percentage in which a company sells its products. o If a company’s unit sales are 80% printers and 20% computers, its sales mix is 80% to 20%. o Sales mix is important because different products often have very different contribution margins. o Companies can compute break-even sales for a mix of two or more products by determining the weighted average unit contribution margin of all the products. ▯ Illustration: Vargo Video sells not only camcorders but TV sets as well. Vargo sells its two products in the following amounts: 1,500 camcorders and 500 TVs. The sales mix, expressed as a function of total units sold, is as follows. o With a break-even point of 1,000 units, Vargo must sell: ▯ 750 Camcorders (1,000 units x 75%) ▯ 250 TVs (1,000 units x 25%) o At this level, the total contribution margin will equal the fixed costs of $275,000. - Break Even Sales in Dollars: o Works well if the company has many products. o Calculates break-even point in terms of sales dollars for ▯ Divisions or ▯ Product lines, ▯ NOT individual products. o Example: First, determine the weighted-average contribution margin. o Second, calculate break-even point in dollars. o With break-even sales of $937,500 and a sales mix of 20% to 80%, Kale must sell: ▯ $187,500 from the Indoor Plant division ▯ $750,000 from the Outdoor Plant division o If the sales mix becomes 50% to 50%, the weighted average contribution margin ratio changes to 35%, resulting in a lower break-even point of $857,143. - Determining Sales Mix with Limited Resources: o All companies have limited resources whether it be floor space, raw materials, direct labor hours, etc. o Management must decide which products to sell to maximize net income. ▯ Illustration: Vargo makes camcorders and TVs. Machine capacity is limited to 3,600 hours per month. ▯ Calculate the contribution margin per unit of: ▯ Management should produce more camcorders if demand exists or else increase machine capacity. ▯ If Vargo is able to increase machine capacity from 3,600 hours to 4,200 hours, the additional 600 hours could be used to produce either the camcorders or TVs. ▯ To maximize net income, all 600 hours should be used to produce and sell camcorders. - Sales Mix with Limited Resources: o Theory of Constraints: ▯ Approach used to identify and manage constraints so as to achieve company goals. ▯ Company must continually • Identify its constraints and • Find ways to reduce or eliminate them, where appropriate. o Question: If the contribution margin per unit is $15 and it takes 3.0 machine hours to produce the unit, the contribution margin per unit of limited resource is: ▯ A. $25 ▯ B. $5 ▯ C. $4 ▯ D. No correct answer is given - Cost Structure: o Cost Structure is the relative proportion of fixed versus variable costs that a company incurs. o May have a significant effect on profitability. o Company must carefully choose its cost structure. o Illustration: Vargo Video and one of its competitors, New Wave Company, both make camcorders. Vargo Video uses a traditional, labor-intensive manufacturing process. New Wave Company has invested in a completely automated system. The factory employees are involved only in setting up, adjusting, and maintaining the machinery. o New Wave contributes 80 cents to net income for each dollar of increased sales while Vargo only contributes 40 cents. o New Wave’s cost structure, which relies on fixed costs, is more sensitive to changes in sales. o New Wave needs to generate $150,000 more in sales than Vargo to break-even. o Because of the greater break-even sales required, New Wave is a riskier company than Vargo. o The difference in ratios reflects the difference in risk between New Wave and Vargo. o Vargo can sustain a 38% decline in sales before operating at a loss versus only a 19% decline for New Wave. - Operating Leverage: o Extent that net income reacts to a given change in sales. o Higher fixed costs relative to variable costs cause a company to have higher operating leverage. o When sales revenues are increasing, high operating leverage means that profits will increase rapidly. o When sales revenues are declining, too much operating leverage can have devastating consequences. ▯ Degree of Operating Leverage: • Provides a measure of a company’s earnings volatility. • Computed by dividing total contribution margin by net income. ▯ New Wave’s earnings would go up (or down) by about two times (5.33 ÷ 2.67 = 1.99) as much as Vargo’s with an equal increase in sales. o Question: The degree of operating leverage: ▯ A. Can be computed by dividing total contribution margin by net income. ▯ B. Provides a measure of the company’s earnings volatility. ▯ C. Affects a company’s break-even point. ▯ D. All of the above. - Appendix 6A: o Under variable and absorption, product costs consist of: ▯ Direct Materials ▯ Direct Labor ▯ Variable Manufacturing Overhead o The difference between absorption and variable costing is: - Variable versus Absorption Costing: o The difference between absorption and variable costing: o Under both costing methods, selling and administrative expenses are treated as period costs. o Companies may not use variable costing for external financial reports because GAAP requires that fixed manufacturing overhead be treated as a product cost. - Comparing Absorption with Variable Costing: o Illustration: Premium Products Corporation manufactures a polyurethane sealant, called Fix-It, for car windshields. Relevant data for Fix-It in January 2017, the first month of production, are as follows. o The manufacturing cost per unit is $4 ($13 -$9) higher for absorption costing because fixed manufacturing costs are treated as product costs. o Absorption Costing Example: o Variable Costing Example: o Question: Fixed manufacturing overhead costs are recognized as: ▯ a. Period costs under absorption costing. ▯ b. Product costs under absorption costing. ▯ c. Product costs under variable costing. ▯ d. Part of ending inventory costs under both absorption and variable costing. - Decision Making Concerns: o Generally accepted accounting principles require that absorption costing be used for the costing of inventory for external reporting purposes. o Net income measured under GAAP (absorption costing) is often used internally to ▯ Evaluate performance, ▯ Justify cost reductions, or ▯ Evaluate new projects. o Some companies have recognized that net income calculated using GAAP does not highlight differences between variable and fixed costs and may lead to poor business decisions. o These companies use variable costing for internal reporting purposes. - Potential Advantages of Variable Costing: o The use of variable costing is consistent with cost–volume–profit analysis. o Net income under variable costing is unaffected by changes in production levels. Instead, it is closely tied to changes in sales. o The presentation of fixed costs in the variable costing approach makes it easier to identify fixed costs and to evaluate their impact on the company’s profitability. Accounting 210: Chapter 7 Notes Incremental Analysis - Making decisions is an important management function. o Does not always follow a set pattern. o Decisions vary in scope, urgency, and importance. o Steps usually involved in process include: o o In making business decisions, o Considers both financial and non-financial information. ▯ ►Revenues and costs, and ▯ ►Effect on overall profitability. ▯ ►Effect on employee turnover ▯ ►The environment o Overall company image. - Incremental Analysis Approach o Process used to identify the financial data that change under alternative courses of action. ▯ ►Both costs and revenues may vary or ▯ ►Only revenues may vary or ▯ ►Only costs may vary o o Incremental revenue is $15,000 less under Alternative B. o Incremental cost savings of $20,000 is realized. o Alternative B produces $5,000 more net income. o Sometimes involves changes that seem contrary to intuition. o Variable costs sometimes do not change under alternatives. o Fixed costs sometimes change between alternatives. - Types of Incremental Analysis o Common types of decisions involving incremental analysis: o 1.Accept an order at a special price. o 2.Make or buy component parts or finished products. o 3.Sell or process further them further o 4.Repair, retain, or replace equipment. o 5.Eliminate an unprofitable business segment or product. - Accept an Order at a Special Price o Obtain additional business by making a major price concession to a specific customer. o Assumes that sales of products in other markets are not affected by special order. o Assumes that company is not operating at full capacity. o o Fixed costs do not change since within existing capacity – thus fixed costs are not relevant. o Variable manufacturing costs and expected revenues change – thus both are relevant to the decision. o DO IT! Cobb Company incurs costs of $28 per unit ($18 variable and $10 fixed) to make a product that normally sells for $42. A foreign wholesaler offers to buy 5,000 units at $25 each. Cobb will incur additional shipping costs of $1 per unit. Compute the increase or decrease in net income Cobb will realize by accepting the special order, assuming Cobb has excess operating capacity. Should Cobb Company accept the special order? o Illustration: Baron Company incurs the following annual costs in producing 25,000 ignition switches for motor scooters. ▯ Total manufacturing cost is $1 higher per unit than purchase price. ▯ Must absorb at least $50,000 of fixed costs under either option. - Opportunity Cost o Illustration: Assume that through buying the switches, Baron Company can use the released productive capacity to generate additional income of $38,000 from producing a different product. This lost income is an additional cost of continuing to make the switches in the make-or-buy decision. o DO IT! Juanita Company must decide whether to make or buy some of its components for the appliances it produces. The costs of producing 166,000 electrical cords for its appliances are as follows. Direct materials $90,000 Variable overhead $32,000 Direct labor 20,000 Fixed overhead 24,000 Instead of making the electrical cords at an average cost per unit of $1.00 ($166,000 ÷ 166,000), the company has an opportunity to buy the cords at $0.90 per unit. If the company purchases the cords, all variable costs and one-fourth of the fixed costs will be eliminated. (a) Prepare an incremental analysis showing whether the company should make or buy the electrical cords. (b) Will your answer be different if the released productive capacity will generate additional income of $5,000? o Yes, net income will be increased by $3,600 if Juanita Company purchases the electrical cords rather than making them. - Sell or Process Further o May have option to sell product at a given point in production or to process further and sell at a higher price. o Decision Rule: o Process further as long as the incremental revenue from such processing exceeds the incremental processing costs. - Single Product Case o Illustration: Woodmasters Inc. makes tables. The cost to manufacture an unfinished table is $35. The selling price per unfinished unit is $50. Woodmasters has unused capacity that can be used to finish the tables and sell them at $60 per unit. For a finished table, direct materials will increase $2 and direct labor costs will increase $4. Variable manufacturing overhead costs will increase by $2.40 (60% of direct labor). No increase is anticipated in fixed manufacturing overhead. - Multiple Product Case o Joint product situation for Marais Creamery. Cream and skim milk are products that result from the processing of raw milk. o Joint product costs are sunk costs and thus not relevant to the sell-or-process further decision. o Cost and revenue data per day for skim milk. - DO IT: Easy Does It manufactures unpainted furniture for the do-it- yourself (DIY) market. It currently sells a child’s rocking chair for $25. Production costs are $12 variable and $8 fixed. Easy Does It is considering painting the rocking chair and selling it for $35. Variable costs to paint each chair are expected to be $9, and fixed costs are expected to be $2.Prepare an analysis showing whether Easy Does It should sell unpainted or painted chairs. - Illustration: Jeffcoat Company is considering replacing a factory machine with a new machine. Jeffcoat Company has a factory machine that originally cost $110,000. It has a balance in Accumulated Depreciation of $70,000, so its book value is $40,000. It has a remaining useful life of four years. The company is considering replacing this machine with a new machine. A new machine is available that costs $120,000. It is expected to have zero salvage value at the end of its four-year useful life. If the new machine is acquired, variable manufacturing costs are expected to decrease from $160,000 to $125,000 and the old unit could be sold for $5,000. The incremental analysis for the four-year period is as follows. - Repair, Retain, or Replace Equipment o Additional Considerations ▯ The book value of old machine does not affect the decision. • ►Book value is a sunk cost. • ►Costs which cannot be changed by future decisions (sunk cost) are not relevant in incremental analysis. o However, any trade-in allowance or cash disposal value of the existing asset is relevant. - DO IT! Rochester Roofing is faced with a decision. The company relies very heavily on the use of its 60-foot extension lift for work on large homes and commercial properties. Last year, the company spent $60,000 refurbishing the lift. It has just determined that another $40,000 of repair work is required. Alternatively, Rochester Roofing has found a newer used lift that is for sale for $170,000. The company estimates that both the old and new lifts would have useful lives of 6 years. However, the lift is more efficient and thus would reduce operating expenses by about $20,000 per year. The company could also rent out the new lift for about $2,000 per year. The old lift is not suitable for rental. The old lift could currently be sold for $25,000 if the new lift is purchased. Prepare an incremental analysis that shows whether the company should repair or replace the equipment. - The analysis indicates that purchasing the new machine would increase net income for the 6-year period by $27,000. o Key: Focus on Relevant Costs. o Consider effect on related product lines. o Fixed costs allocated to the unprofitable segment must be absorbed by the other segments. o Net income may decrease when an unprofitable segment is eliminated. o Decision Rule: Retain the segment unless fixed costs eliminated exceed contribution margin lost. - Eliminate an Unprofitable Segment or Product o Illustration: Venus Company manufactures three models of tennis rackets: o Profitable lines: Pro and Master o Unprofitable line: Champ o Prepare income data after eliminating Champ product line. Assume fixed costs are allocated 2/3 to Pro and 1/3 to Master. o Incremental analysis of Champ provided the same results: ▯ Do Not Eliminate Champ o Assume that $22,000 of the fixed costs attributed to the Champ line can be eliminated if the line is discontinued. ▯ Eliminate Champ - DO IT! Lambert, Inc. manufactures several types of accessories. For the year, the knit hats and scarves line had sales of $400,000, variable expenses of $310,000, and fixed expenses of $120,000. Therefore, the knit hats and scarves line had a net loss of $30,000. If Lambert eliminates the knit hats and scarves line, $20,000 of fixed costs will remain. Prepare an analysis showing whether the company should eliminate the knit hats and scarves line. Accounting 210: Chapter 8 Notes Pricing - The price of a good or service is affected by many factors. - Regardless of the factors involved, the price must cover the costs of the good or service as well as earn a reasonable profit. - Pricing Goods for External Sales: o The price of a good or service is affected by many factors. o Company must have a good understanding of market forces. o Where products are unique or clearly distinguishable from competitor goods, prices are set by the company. - Target Costing: o Laws of supply and demand significantly affect product price. o To earn a profit, companies must focus on controlling costs. o Requires setting a target cost that will provide the company’s desired profit. o Target cost: Cost that provides the desired profit when the market determines a product’s price. ▯ Market Price – Desired Profit = Target Cost o If a company can produce its product for the target cost or less, it will meet its profit goal. o First, company should identify its market niche where it wants to compete. o Second, company conducts market research to determine the target price – the price the company believes will place it in the optimal position for the target consumers. o Third, company determines its target cost by setting a desired profit. o Last, company assembles a team to develop a product to meet the company’s goals. ▯ DO IT! Fine Line Phones is considering introducing a fashion cover for its phones. Market research indicates that 200,000 units can be sold if the price is no more than $20. If Fine Line decides to produce the covers, it will need to invest $1,000,000 in new production equipment. Fine Line requires a minimum rate of return of 25% on all investments. Determine the target cost per unit for the cover. o Question: Target cost related to price and profit means that: ▯ a. Cost and desired profit must be determined before selling price. ▯ b. Cost and selling price must be determined before desired profit. ▯ c. Price and desired profit must be determined before costs. ▯ d. Costs can be achieved only if the company is at full capacity. - Cost-Plus Pricing: o In an environment with little or no competition, a company may have to set its own price. o When a company sets price, the price is normally a function of product cost: cost-plus pricing. o Approach requires establishing a cost base and adding a markup to determine a target- selling price. o In determining the proper markup, a company must consider competitive and market conditions. o Size of the markup (the “plus”) depends on the desired return on investment for the product: ▯ ROI = net income ÷ invested assets o Illustration: Thinkmore Products, Inc. is in the process of setting a selling price on its new video camera pen. It is a functioning pen that will record up to 2 hours of audio and video. The per unit variable cost estimates for the new video camera pen are as follows. ▯ In addition, Thinkmore has the following fixed costs per unit at a budgeted sales volume of 10,000 units. ▯ Thinkmore has decided to price its new video camera pen to earn a 20% return on its investment (ROI) of $2,000,000. ▯ Markup = 20% ROI of $2,000,000 ▯ Expected ROI = $400,000 ÷ 10,000 units = $40 ▯ Market Price per Unit= o Compute the markup percentage to achieve a desired ROI of $20 per unit: o Compute the target selling price: o LIMITATIONS OF COST-PLUS PRICING: ▯ Advantage of cost-plus pricing: Easy to compute. ▯ Disadvantages: • Does not consider demand side: o Will the customer pay the price? • Fixed cost per unit changes with change in sales volume: o At lower sales volume, company must charge higher price to meet desired ROI. ▯ Illustration: If budgeted sales volume for Thinkmore’s Products was 5,000 instead of 10,000, Thinkmore’s variable cost per unit would remain the same. However, the fixed cost per unit would change as follows. ▯ Thinkmore's desired 20% ROI now results in a $80 ROI per unit [(20% x $2,000,000) ÷ 5,000]. ▯ Thinkmore computes the selling price at 5,000 units as follows: ▯ At 5,000 units, how much would Thinkmore mark up its total unit costs to earn a desired ROI of $80 per unit. - Variable-Cost Pricing: o Alternative pricing approach: ▯ Simply add a markup to variable costs. ▯ Avoids the problem of uncertain cost information related to fixed-cost-per-unit computations. ▯ Helpful in pricing special orders or when excess capacity exists. o Major disadvantage is that managers may set the price too low and fail to cover fixed costs. o Question: Cost-plus pricing means that: o a. Selling price = variable cost + (markup percentage + variable cost). o b. Selling price = cost + (markup percentage X cost). o c. Selling price = manufacturing cost + (markup percentage + manufacturing cost). o d. Selling price = fixed cost + (markup percentage X fixed cost). - DO IT! Air Corporation produces air purifiers. The following per unit cost information is available: direct materials $16, direct labor $18, variable manufacturing overhead $11, variable selling and administrative expenses $6. Fixed selling and administrative expenses are $50,000, and fixed manufacturing overhead is $150,000. Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target selling price. o Using a 45% markup percentage on total per unit cost and assuming 10,000 units, compute the target selling price. o Vertically integrated companies: ▯ Grow in either direction of its suppliers or its customers. ▯ Frequently transfer goods to other divisions as well as outside customers. - Transfer Price: o Transfer price - price used to record the transfer between two divisions of a company. o Conceptually o Due to practical considerations, companies often use the other two methods. o Illustration: Alberta Company makes rubber soles for work & hiking boots. o Two Divisions: ▯ Sole Division - sells soles externally. ▯ Boot Division- makes leather uppers for hiking boots which are attached to purchased soles. o Division managers compensated on division profitability. o Management now wants Sole Division to provide at least some soles to the Boot Division. o Computation of the contribution margin per unit for each division when the Boot Division purchases soles from an outside supplier. o - No Excess Capacity: o If Sole sells to Boot, ▯ payment must at least cover variable cost per unit plus ▯ its lost contribution margin per sole (opportunity cost). o The minimum transfer price acceptable to Sole is: o From the perspective of the Boot Division (the buyer), the most it will pay is what the sole would cost from an outside supplier. o Can produce 80,000 soles, but can sell only 70,000. o Available capacity of 10,000 soles. o Contribution margin of $7 per unit is not lost. o Minimum transfer price acceptable to Sole: o In this case, the Boot Division and the Sole Division should negotiate a transfer price within the range of $11 to $17. - Variable Costs: o In the minimum transfer price formula, variable cost is the variable cost of units sold internally. o May differ - higher or lower - for units sold internally versus those sold externally. o The minimum transfer pricing formula can still be used – just use the internal variable costs. - Summary: o Transfer prices established: ▯ Minimum by selling division. ▯ Maximum by the purchasing division. o Often not used because: ▯ Market price information sometimes not easily obtainable. ▯ Lack of trust between the two divisions. ▯ Different pricing strategies between divisions. - Cost-Based Transfer Prices: o Uses costs incurred by the division producing the goods as its foundation. o May be based on variable costs alone or on variable costs plus fixed costs. o Selling division may also add markup. o Can result in improper transfer prices causing: ▯ Loss of profitability for company. ▯ Unfair evaluation of division performance. o Illustration: Alberta Company requires the division to use a transfer price based on the variable cost of the sole. With no excess capacity, the contribution margins per unit for the two divisions are: Cost-based transfer price—10,000 units o Cost-based pricing is bad deal for Sole Division – no profit on transfer of 10,000 soles to Boot Division and loses profit of $70,000 on external sales. o Boot Division is very happy; increases contribution margin by $6 per sole. o If Sole Division has excess capacity, the division reports a zero profit on these 10,000 units and the Boot Division gains $6 per unit. ▯ Overall, the Company is worse off by $60,000. o Does not reflect the division’s true profitability nor provide adequate incentive for the division to control costs. - Market- Based Transfer Prices: o Based on existing market prices of competing goods. o Often considered best approach because it is objective and generally provides the proper economic incentives. o It is indifferent between selling internally and externally if can charge/pay market price. o Can lead to bad decisions if have excess capacity. o Why? No opportunity cost. o Where there is not a well-defined market price, companies use cost-based systems. o The Plastics Division of Weston Company manufactures plastic molds and then sells them for $70 per unit. Its variable cost is $30 per unit, and its fixed cost per unit is $10. Management would like the Plastics Division to transfer 10,000 of these molds to another division within the company at a price of $40. The Plastics Division is operating at full capacity. What is the minimum transfer price that the Plastics Division should accept? ▯ A. $10 ▯ B. $30 ▯ C. $40 ▯ D. $70 - Effect of Outsourcing on Transfer Pricing: o Outsourcing - Contracting with an external party to provide a good or service, rather than doing the work internally. o Virtual companies outsource all of their production. o Use incremental analysis to determine if outsourcing is profitable. o As companies increasingly rely on outsourcing, fewer components are transferred internally thereby reducing the need for transfer pricing. - Transfers Between Divisions in Different Countries: o Companies “globalize” their operations o Going global increases transfers between divisions located in different countries. o 60% of trade between countries is estimated to be transfers between divisions. o Different tax rates make determining appropriate transfer price more difficult. o DO IT! The clock division of Control Central Corporation manufactures clocks and then sells them to customers for $10 per unit. Its variable cost is $4 per unit, and its fixed cost per unit is $2.50. Management would like the clock division to transfer 8,000 of these clocks to another division within the company at a price of $5. The clock division could avoid $0.50 per clock of variable packaging costs by selling internally. (a) Determine the minimum transfer price, assuming the clock division is not operating at full capacity. (b) Determine the minimum transfer price, assuming the clock division is operating at full capacity. ▯ Opportunity cost + Variable cost = Minimum transfer price
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