The Clover Company manufactures and sells television sets. Its assembly division (AD) buys television screens from the screen division (SD) and assembles the TV sets. The SD, which is operating at capacity, incurs an incremental manufacturing cost of $ 90 per screen. The SD can sell all its output to the outside market at a price of $ 135 per screen, after incurring a variable marketing and distribution cost of $ 6 per screen. If the AD purchases screens from outside suppliers at a price of $ 135 per screen, it will incur a variable purchasing cost of $ 2 per screen. Clover’s division managers can act autonomously to maximize their own division’s operating income.
1. What is the minimum transfer price at which the SD manager would be willing to sell screens to the AD?
2. What is the maximum transfer price at which the AD manager would be willing to purchase screens from the SD?
3. Now suppose that the SD can sell only 85% of its output capacity of 5,000 screens per month on the open market. Capacity cannot be reduced in the short run. The AD can assemble and sell more than 5,000 TV sets per month.
a. What is the minimum transfer price at which the SD manager would be willing to sell screens to the AD?
b. From the point of view of Clover’s management, how much of the SD output should be transferred to the AD?
c. If Clover mandates the SD and AD managers to “split the difference” on the minimum and maximum transfer prices they would be willing to negotiate over, what would be the resulting transfer price? Does this price achieve the outcome desired in requirement 3b?