Knott Radio Corporation is a subsidiary of Mercer Companies. Knott makes car radios that it sells to retail outlets. It purchases speakers for the radios from outside suppliers for $28 each. Recently, Mercer acquired the Ruddy Speaker Corporation, which makes car radio speakers that it sells to manufacturers. Ruddy produces and sells approximately 200,000 speakers per year, which represents 70 percent of its operating capacity. At the present volume of activity, each speaker costs $24 to produce. This cost consists of a $16 variable cost component and an $8 fixed cost component. Ruddy sells the speakers for $30 each. The managers of Knott and Ruddy have been asked to consider using Ruddy’s excess capacity to supply Knott with some of the speakers that it currently purchases from unrelated companies. Both managers are evaluated based on return on investment. Ruddy’s manager suggests that the speakers be supplied at a transfer price of $30 each (the current selling price). On the other hand, Knott’s manager suggests a $28 transfer price, noting that this amount covers total cost and provides Ruddy a healthy contribution margin.

Required
a. What transfer price would you recommend?
b. Discuss the effect of the intercompany sales on each manager’s return on investment.
c. Should Ruddy be required to use more than excess capacity to provide speakers to Knott? In other words, should it sell to Knott some of the 200,000 units that it is currently selling to unrelated companies? Why or why not?