Question

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Rooney Radio Corporation is a subsidiary of Salem Companies. Rooney makes car radios that it sells to retail outlets. It purchases speakers for the radios from outside suppliers for $41 each. Recently, Salem acquired the Franklin Speaker Corporation, which makes car radio speakers that it sells to manufacturers. Franklin produces and sells approximately 300,000 speakers per year, which represents 70 percent of its operating capacity. At the present volume of activity, each speaker costs $31 to produce. This cost consists of a $21 variable cost component and an $10 fixed cost component. Franklin sells the speakers for $43 each. The managers of Rooney and Franklin have been asked to consider using Franklin's excess capacity to supply Rooney with some of the speakers that it currently purchases from unrelated companies. Both managers are evaluated based on return on investment. Franklin's manager suggests that the speakers be supplied at a transfer price of $43 each (the current selling price). On the other hand, Rooney's manager suggests a $41 transfer price, noting that this amount covers total cost and provides Franklin a healthy contribution margin. Required a. Based on market prices suggested by the managers, which transfer price would you recommend? Transfer price

Answer 1

Since there exists spare capacity, the relevant cost for additional speakers is equal to the variable cost per unit

I.e. $21 per unit

Any price above it will provide positive income for Franklin and will increase its return on investment

The maximum price Rooney can pay is equal to the price it is currently paying I.e. $41 each

Any price below it will increase the income

Rooney will not agree for a price exceeding $41

Hence, the price should be fixed between $21 and $41

Recommended price is $41 since the Rooney is ready to buy at $41