Question

Transfer Pricing

Aulman Inc. has a number of divisions including a Furniture Division and a Motel Division. The Motel Division owns and operates a line of budget motels located along major highways. Each year, the Motel Division purchases furniture for the motel rooms. Currently, it purchases a basic dresser from an outside supplier for $50. The manager of the Furniture Division has approached the manager of the Motel Division about selling dressers to the Motel Division. The full product cost of a dresser is $29.

While the Furniture Division has been operating at capacity (50,000 dressers per year) and selling them for $50 each, it expects to produce and sell only 40,000 dressers for $50 next year. The Furniture Division incurs variable costs of $16 per dresser.

The Motel Division needs 10,000 dressers per year; the Furniture Division can make up to 50,000 dressers per year. The company policy is that all transfer prices are negotiated by the divisions involved. Suppose that the two divisions agree on a transfer price of $35.

Required:

What is the change in operating income for the Furniture Division? Round your answer to the nearest dollar, if required.
$fill in the blank 1

Answer 1

Part (1)

Maximum transfer price which Motel division would like to pay will be the current purchase price from outside market i.e. $50

Part (2)

Calculation of Minimum Transfer price to be charged by Furniture Division-

Cost to be incurred due to transfer = $12

So, Minimum transfer price would be $12

Note- No contribution will be lost by the Furniture Division,as there is spare capacity to produce 10,000 dressers, because there is demand of 40,000 dressers from outside market next year.

Part (3)

Calculation of Profit if transfer is not made-

Furniture Division

Sales = (40,000 dressers* $50 per dresser) = $2,000,000

Less- Variable Costs= (40,000* $12) = $480,000

Contribution = $1,520,000

Less- Fixed Costs = (29-12)*50,000 = $850,000

Profit = $670,000

Motel Division

Purchase Cost from Outside Market = (10,000 Dressers*$50) = $500,000

Company as a whole

Profit of Furniture Division- Cost of Motel Division

= $670,000-$500,000

= $170,000

Calculation of profit if transfer is made at $34 -

Furniture Division

Sales in outside market = (40,000*$50) = $2,000,000

Add- Transfer to Motel Division = (10,000*$34) = $340,000

Total Receipts = $2,340,000

Less- Variable Costs = (50,000*$12) =$600,000

Contribution = $1,740,000

Less - Fixed Costs = $850,000

Profit = $890,000

Motel Division

Transfer Cost = (10,000*$34) = $340,000

Company as a whole

Profit of Furniture Division- Cost of Motel Division

= $890,000-$340,000

= $550,000

So, from the above analysis-

Benefit to Furniture Division = $890,000-$670,000

= $220,000

Benefit to Motel Division = $500,000-$340,000

= $160,000

Benefit to Company as a whole = $550,000-$170,000

= $380,000