The management of James Corporation has decided to
implement a transfer pricing system. James’ MIS department is
currently negotiating a transfer price for its services with the four
producing divisions of the company as well as the marketing
department. Charges will be assessed based on number of reports
(assume that all reports require the same amount of time
and resources to produce). The cost to operate the MIS department
at its full capacity of 1,000 reports per year is budgeted at
$45,000. The user subunits expect to request 250 reports each
this year. The cost of temporary labor and additional facilities
used to produce reports beyond capacity is budgeted at $48.00
per report. James could purchase the same services from an external
Information Services firm for $70,000. What amounts
should be used as the ceiling and the floor in determining the
negotiated transfer price?

(b) Negotiated transfer prices should fall within a range
limited by a ceiling and a floor. The ceiling is the lowest market
price that could be obtained from an external supplier, and the
floor equals the outlay costs plus opportunity cost of the transferring
division. Since James’ MIS department does not have to
option to sell services to external customers, its opportunity cost
is $0. Since all costs of service departments must be covered by
the revenue-producing departments, the MIS department’s outlay
cost equals its total costs. The department’s full capacity level
is 1,000 reports per year. However, the user departments will be
requesting 1,250 reports (5 user subunits × 250 reports each).
Thus, the MIS department will incur costs of $12,000 [$48 ×
(1,250 – 1,000)] for the 250 reports above capacity, in addition
to the $45,000 budgeted costs for full capacity. The total cost of
$57,000 ($45,000 + $12,000) is used to calculate the floor. The
ceiling is based on the $70,000 that would be incurred to purchase
MIS services externally. Since the MIS department will be
producing 1,250 reports, the floor is $45.60 ($57,000 ÷ 1,250),
and the ceiling is $56.00 ($70,000 ÷ 1,250). At full capacity, any
differential costs of additional production are added to the floor.
$48.00 represents only the differential cost of producing each
report above full capacity, not cost per report for total production.
Budgeted costs are based on production of 1,250 reports,
not 1,000.