The Fresno Corporation makes water pumps. The Engine Division makes the engines and supplies them to the Assembly Division, where the pumps are assembled. Fresno is a profitable corporation that attributes much of its success to its decentralized structure. Each division manager is compensated on the basis of division operating income.

The Assembly Division currently acquires all its engines from the Engine Division. The Assembly Division manager could purchase similar engines in the market for $ 400 each. The Engine Division is currently operating at 80% of its capacity of 4,000 units and has the following costs:

Direct materials ($ 125 per unit * 3,200 units) ...........$ 400,000

Direct manufacturing labor ($ 50 per unit * 3,200 units) .......160,000

Variable manufacturing overhead ($ 25 per unit * 3,200 units) ......80,000

Fixed manufacturing overhead costs ...............520,000

All the Engine Division’s 3,200 units are currently transferred to the Assembly Division. No engines are sold in the external market.

The Engine Division has just received an order for 2,000 units at $ 375 per engine that would utilize half the capacity of the plant. The order must either be taken in full or rejected. The order is for a slightly different engine than what the Engine Division currently makes. To produce the new engine would require a direct material cost per unit of $ 100, a direct manufacturing labor cost per unit of $ 40, and a variable manufacturing overhead cost per unit of $ 25.

Required

1. From the viewpoint of the Fresno Corporation as a whole, should the Engine Division accept the order for the 2,000 units? Show your computations.

2. What range of transfer prices will result in achieving the actions determined to be optimal in requirement 1 if division managers act in a decentralized manner?

3. The manager of the Assembly Division has proposed a transfer price for the engines equal to the full cost of the engines, including an allocation of overhead cost. The Engine Division allocates overhead cost to engines on the basis of the total capacity of the plant used to manufacture the engines.

a. Calculate the transfer price for the engines transferred to the Assembly Division under this arrangement.

b. Do you think the transfer price calculated in requirement 3a will result in achieving the actions deter-mined to be optimal in requirement 1 if division managers act in a decentralized manner?

c. Comment in general on one advantage and one disadvantage of using full cost of the producing division as the basis for setting transfer prices.

4. Now consider the effect of income taxes.

a. Suppose the Assembly Division is located in a state that imposes a 10% tax on income earned within its boundaries and the Engine Division is located in a state that imposes no tax on income earned within its boundaries. What transfer price would be chosen by Fresno Corporation to minimize state income taxes for the company as a whole? Assume that only transfer prices greater than or equal to full manufacturing cost and less than or equal to the market price of “substantially similar” engines are acceptable to the tax authorities.

b. Suppose that the Fresno Corporation announces the transfer price computed in requirement 4a to price all transfers between the Engine and Assembly divisions. Each division manager then acts autonomously to maximize division operating income. Will division managers acting in a decentralized manner achieve the actions determined to be optimal in requirement 1? Explain.

5. Consider your response to requirements 1– 4 and assume the Engine Division will continue to have opportunities for outside business as described in requirement 1. What transfer- pricing policy would you recom-mend Fresno use, and why? Would you continue to evaluate division performance on the basis of division operating incomes? Explain.