Question

Transfer Pricing, Idle Capacity

Mouton & Perrier, Inc., has a number of divisions that produce liquors, bottled water, and glassware. The Glassware Division manufactures a variety of bottles that can be sold externally (to soft-drink and juice bottlers) or internally to Mouton & Perrier’s Bottled Water Division. Sales and cost data on a case of 24 basic 12-ounce bottles are as follows:

Unit selling price	$3.05
Unit variable cost	$1.30
Unit product fixed cost*	$0.65
Practical capacity in cases	540,000
*$351,000/540,000

During the coming year, the Glassware Division expects to sell 430,000 cases of this bottle. The Bottled Water Division currently plans to buy 99,430 cases on the outside market for $3.05 each. Ellyn Burridge, manager of the Glassware Division, approached Justin Thomas, manager of the Bottled Water Division, and offered to sell the 99,430 cases for $2.98 each. Ellyn explained to Justin that she can avoid selling costs of $0.13 per case by selling internally and that she would split the savings by offering a $0.07 discount on the usual price.

Required:

1. What is the minimum transfer price that the Glassware Division would be willing to accept? Round to the nearest cent.
$ per unit

What is the maximum transfer price that the Bottled Water Division would be willing to pay? Round to the nearest cent.
$ per unit

Should an internal transfer take place?

What would be the benefit (or loss) to the firm as a whole if the internal transfer takes place? When required, round your answer to the nearest dollar.
  $

2. Suppose Justin knows that the Glassware Division has idle capacity. Do you think that he would agree to the transfer price of $2.98?

Suppose he counters with an offer to pay $2.48. If you were Ellyn, would you be interested in this price?

3. Suppose that Mouton & Perrier’s policy is that all internal transfers take place at full manufacturing cost. What would the transfer price be? Round to the nearest cent.
$ per unit

Would the transfer take place?

Answer 1

Solution 1):

	Units
Maximum Capacity of Production	5,40,000.00
Less: Expected Sales	4,30,000.00
Excess Capacity	1,10,000.00

As Glassware Division has an excess capacity, the minimum transfer price Glassware Division would accept:

= Total Variable Cost per Unit – Selling Cost per unit

= $1.30 - $0.13 = $1.17

The maximum transfer price the Bottled Water Division would be willing to pay will be equal to the Market Price of the bottle in the outside market i.e $3.05.

Calculation of Profit or loss to the firm if the transfer takes place at $2.98 per bottle

	Per Unit	Total (99,430 Bottles)
Net benfit to Glassware Division on Transfer = Contribution Earned = Transfer Price - (Variable Cost per Unit - Variable Selling Cost)	1.81	179968.3
Add: Net Benefit to Bottled Water Division on Transfer ($3.05-$2.98)	0.07	6960.1
Net Benefit to Mouton & Perrier, Inc.		186928.4

Therefore, the internal transfer should take place as Mouton & Perrier, Inc.is benefitting by $18,6928.

Solution 2) If Justin knows that the Glassware Division has idle capacity, he would not agree to the transfer price of $2.98 as he would negotiate the transfer price to the minimum i.e. $1.17 per bottle.

Suppose Justin counters with an offer to pay $2.48, still it would be profitable for the Glassware Division. The Profit per bottle = $2.48 - $1.17 = $1.31 per bottle.

Hence, I would have been in the place of Ellyn Burridge, I would accept the offer.

Solution 3) If Mouton & Perrier’s policy is that all internal transfers take place at full manufacturing cost. Transfer Price will be:

	$
Unit variable cost = Total Variable Cost per Unit - Variable Selling Cost	1.17
Unit product fixed cost = $351,000/529,430 Units	0.66
Full Manufacturing Cost	1.83

Note: Total Units will be taken as 529,430 Units as Expected Sales of Glassware Division 430,000 units + Units to be transferred 99,430 units.

If Mouton & Perrier’s policy is that all internal transfers take place at full manufacturing cost, still the transfer would take place as it would be profitable for the company.

	Per Unit	Total (99,430 Bottles)
Net benefit to Glassware Division on Transfer = $2.48 - $1.83	0.65	64629.5
Add: Net Benefit to Bottled Water Division on Transfer ($3.05-$1.83)	1.22	121304.6
Net Benefit to Mouton & Perrier, Inc.		185934