Question

Chapin, Inc., owns a number of food service companies. Two divisions are the Coffee Division and the Donut Shop Division. The Coffee Division purchases and roasts coffee beans for sale to supermarkets and specialty shops. The Donut Shop Division operates a chain of donut shops where the donuts are made on the premises. Coffee is an important item for sale along with the donuts and, to date, has been purchased from the Coffee Division. Company policy permits each manager the freedom to decide whether or not to buy or sell internally. Each divisional manager is evaluated on the basis of return on investment and residual income. Recently, an outside supplier has offered to sell coffee beans, roasted and ground, to the Donut Shop Division for $4.00 per pound. Since the current price paid to the Coffee Division is $4.50 per pound, Brandi Alzer, the manager of the Donut Shop Division, was interested in the offer. However, before making the decision to switch to the outside supplier, she decided to approach Raymond Jasson, manager of the Coffee Division, to see if he wanted to offer an even better price. If not, then Brandi would buy from the outside supplier. Upon receiving the information from Brandi about the outside offer, Raymond gathered the following information about the coffee: Direct materials Direct labor Variable overhead Fixed overhead" Total unit cost $0.90 0.40 0.70 1.50 $3.50 *Fixed overhead is based on $1,500,000/1,000,000 pounds. Selling price per pound Production capacity Internal sales $4.50 1,000,000 pounds 100,000 pounds Required: Suppose that the Coffee Division is producing at capacity and can sell all that it produces to outside customers. How should Raymond respond to Brandi's request for a lower transfer price? What will be the effect on firmwide profits? Compute the effect of this response on each division's profits. 2.Now, assume that the Coffee Division is currently selling 950,000 pounds. If no units are sold internally, total.coffee sales will drop to 850,000 pounds. Suppose that Raymond refuses to lower the transfer price from $4.50. Compute the effect on firmwide profits and on each division's profits.

Answer 1

1) Raymond should not reduce the price charged to Brandi if he can sell all he produces at a price of $4.50 per pound. Brandi should buy externally, saving the company $50,000 (100,000 × $0.50). The $50,000 savings belongs to the Donut Shop Division. There will be no effect on the Coffee Division.
2)
Coffee Division
Gross profit if Donut Division buys from Coffee:
Sales (950,000 x $4.50)	$ 4,275,000.00
Less: Variable cost of goods sold (950,000 x $2)	$ 1,900,000.00
Less Fixed Overhead (1,000,000 × $1.50)	$ 1,500,000.00
Gross profit if Donut Division buys from Coffee:	$    875,000.00
Gross profit if Donut Division buys outside:
Sales (850,000 x $4.50)	$ 3,825,000.00
Less: Variable cost of goods sold (850,000 x $2)	$ 1,700,000.00
Less Fixed Overhead (1,000,000 × $1.50)	$ 1,500,000.00
Gross profit if Donut Division buys outside:	$    625,000.00
Decrease in profit for Coffee Division = $625,000 - $875,000	$  (250,000.00)
Increase in profit for Donut Division = ($4.50 – $4.00) × 100,000	$      50,000.00
Overall firm impact = $(250,000) + $50,000 =	$      50,000.00