Question

1. Transfer Pricing with Idle Capacity

   Oriole, 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 $4.30 per pound. Since the current price paid to the Coffee Division is $4.75 per pound, Ashleigh Tremont, 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 Santigui Melendez, manager of the Coffee Division, to see if he wanted to offer an even better price. If not, then Ashleigh would buy from the outside supplier.

   Upon receiving the information from Ashleigh about the outside offer, Santigui gathered the following information about the coffee:

   Direct materials	$0.95
   Direct labor	0.45
   Variable overhead	0.72
   Fixed overhead*	1.53
   Total unit cost	$3.65

   
   ^*Fixed overhead is based on $1,530,000 / 1,000,000 pounds.

   Selling price per pound	$4.75
   Production capacity	1,000,000	pounds
   Internal sales	100,000	pounds

   Required:

   1. 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 Santigui refuses to lower the transfer price from $4.75 and the Donut Division purchases from the external supplier. Compute the effect on each division's profits and on the profits of the firm as a whole. Enter an increase in profits as a positive amount, and enter a decrease as a negative amount.

   Change in profit for Coffee Division	$
   Change in profit for Donut Division	$
   Overall firm impact	$

   2. Refer to Requirement 1. What are the minimum and maximum transfer prices? Round your answers to the nearest cent.

   Maximum transfer price (set by Donut Division)	$  per unit
   Minimum transfer price (set by Coffee Division)	$  per unit

   Suppose that the transfer price is set at the maximum price less $1. Will the two divisions accept this transfer price?  

   Compute the effect on the firm's profits and on each division's profits.

   Coffee Division		$
   Donut Division		$
   Whole firm		$

   3. Suppose that the Coffee Division has operating assets of $2,000,000. Assume that the Coffee Division sells 850,000 pounds to outsiders and 100,000 pounds to the Donut Division at a price of $4.75 per pound. What is divisional ROI based on this situation? Enter your answer as a percentage, rounded to two decimal places. For example, the decimal value .03827 would be entered as "3.83" percent.
   %

   Now, refer to Requirement 2. What will divisional ROI be if the transfer price of the maximum price less $1 is implemented?
   %

Answer 1

Answer with working is given below

1. -$263,000 Chane in profit for Coffe Division (Loss of Contirbtuion at $ 2.63 per unit) Change in profit for Donot Divison (External purchase price - Internal Transfer price) *100,000 Overall Firm Impact $45,000 $218,000 $4.75 Selling price Variable Cost Contirbution per unit $2.12 $2.63 2. Maxmimum Transfer price (Set by Donot Division) External Market price $4.30 $2.63 Minimum Transfer price (Set by Coffee Division) (Variable Cost) Transfer Price ( $4.30 - $1) $3.30 This price can be accepted since it is higher than variable cost and both division gain due to this $118,000 Coffee Division (Increase in Conitrbtuion) ($3.30- $2.12) 100,000 Donot Division ( $ 4.30- $3.30) *100,000 (Savings compared to External Cost) Whole Firm $100,000 $218,000 3. $4,512,500 Sales Less: Variable Cost Direct Material Diect Labor Variable Overheads Total variable Cost Contirbution Less: Fixed Cost Net Operating Income Operating Assets Divisional ROI $902,500 $427,500 $684,000 $2,014,000 $2,498,500 $1,530,000 $968,500 $2,000,000 48.43% External Internal Total $4,037,500 $330,000 $4,367,500 Sales Less: Variable Cost Direct Material Diect Labor Variable Overheads Total variable Cost Contirbution Less: Fixed Cost Net Operating Income Operating Assets Divisional ROI $807,500 $95,000 $902,500 $382,500 $45,000 $427,500 $612,000 $72,000 $684,000 $1,802,000 $212,000 $2,014,000 $2,235,500 $118,000 $2,353,500 $1,530,000 $1,530,000 $705,500 $118,000 $823,500 $2,000,000 41.18%