Question

In Cases 1 to 3 below, assume that Division A has a product that can be sold either to Division B of the same company or to outside customers. The man agers of both divisions a re evaluated based on her own division’s return o n investment (ROI). The managers are free to decide if they will participate in any internal transfers. All transfer prices a re negotiated. Treat each case independently.

Case

1      2          3     4

Division A:

Capacity in units 50,000 300,000 100,000 200,000
Number of units now being sold to outside customers 50,000 300,000 75,000 200,000
Selling price per unit to outside customers $100 $40 $60 $45
Variable costs per unit $63 $19 $35 $30
Fixed costs per unit (based on capacity) $25 $8 $17 $6

Division B:

Number of units needed annually 10,000 70,000 20,000 60,000
Purchase price now being paid to an
outside supplier
$92
$39
$60*
      0

*Before any purchase discount.


Required:

1. Refer to Case 1. A study has indicated that Division A can avoid $5 per unit in variable costs on any sales to Division B. Will the managers agree to a transfer and if so, within what range will the transfer price be? Explain.

2. Refer to Case 2. Assume that Division A can avoid $4 per unit in variable costs on any sales to Division B.

a.    Would you expect any disagreement between the two divisional managers over what the transfer price should be? Explain.

b.   Assume that Division A offers to sell 70,000 units to Division B for $38 per unit and that Division B refuses this price. What will be the loss in potential profits for the company as a whole?

3. Refer to Case 3. Assume that Division B is now receiving a 5% price discount from the outside supplier.

a.    Will the managers agree to a transfer? If so, within what range will the transfer price be?

b.    Assume that Division B offers to purchase 20,000 units from Division A at $52 per unit. If Division A accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why?

Answer 1

Case 1
capacity	50000	sales	50000
Particulars		For outside customers	For Dept B
Variable cost p.u.		63	58
Fixed costs		25	25
Total cost		88	83
Selling price		100
Profit		12
Dept B purchases the same at $92
Dept A can produce the same at $83
Division A can transfer the same at 83 plus profit foregone that is 12 = 95
As any price lower than 95 will mean loss for Division A as it can earn higher profit by selling to outside customers
Range of transfer price will be 95 to 100 for Division A and division B will want below 92
But transfer will not take place since the same will be loss for division B as it can get the same at 92 from outside.
Case 2
a)
capacity	300000	sales	300000
Particulars		For outside customers	For Dept B
Variable cost p.u.		19	15
Fixed costs		8	8
Total cost		27	23
Selling price		40
Profit		13	13
Transfer price for division A (cost plus profit )			36
Purchase price for Division B from outside			39
There will be no disagreement between the managers over transfer.
The transfer price will be between 36 to 38 since both will be at profit from the transfer
b) If Division B refuses to accept 70000 units at $ 38 per unit, the income statement will be as below:
Division A
	Units	price	total
sales	300000	40	12000000
Vvariable cost	300000	19	5700000
Fixed cost	300000	8	2400000
Profit (A)			3,900,000.00
Divison B
	Units	price	total
Purchase (B)	70000	39	2730000
Total income of company		(A-B)	1,170,000.00
Suppose if transfer would have taken place
Division A
	Units	price	total
sales to outside	230000	40	9200000
sales to B	70000	38	2660000
Variable cost (outside)	230000	19	4370000
Variable cost (B)	70000	15	1050000
Fixed cost	300000	8	2400000
Profit (A)			4,040,000.00
Divison B
	Units	price	total
Purchase (B)	70000	38	2660000
Total income of company		(A-B)	1,380,000.00
Thus company as a whole is losing 1380000-1170000 =			210,000.00
Loss in potential profits = $210000