Question 1

The Furniture Division of International Woodworking purchases lumber and makes tables, chairs and other wood furniture. Most of the lumber is purchased from the Portneuf Mill, also a division of International Woodworking. The furniture division and Portneuf Mill are profit centres.

The furniture division manager proposed a new chair that will sell for $150.00. The manager wants to purchase the lumber from Portneuf Mill. Production of 800 chairs is planned, using capacity in the furniture division that is currently idle.

The furniture division can purchase the lumber for each chair from an outside supplier for $60.00. International Woodworkers has a policy that internal transfers are priced at variable cost plus allocated fixed costs.

Assume the following costs for the production of one chair:

Portneuf Mill Furniture Division

Variable costs $40.00 Variable costs:

Allocated fixed cost 30.00 Lumber, Portneuf Mill $70.00

Fully absorbed costs $70.00 Furniture division

variable costs:

Manufacturing 75.00

Selling 10.00

Total variable cost $155.00

Required:

1. Assume that the Portneuf Mill has idle capacity and would incur no additional fixed costs to produce the required lumber. Would the furniture division manager buy the lumber for the chair from the Portneuf Mill, given the existing transfer pricing policy? Why or why not?

2. Calculate the contribution margin for the company as a whole if the manager decides to buy from Portneuf Mill and is able to sell 800 chairs.

3.What transfer price policy would you recommend if the Portneuf Mill always has excess

capacity? Explain why this transfer price policy provides incentives for the managers to act in the best interests of the company as a whole.

4. Explain how the excess capacity affects the recommendation in part 3.

Question 2

Adams International has two large divisions: Oil and Chemical. Oil is in the oil-refining business and its main product is gasoline. Chemical produces and sells a variety of chemical products.

Chemical owns a polystyrene processing plant next to Oil's refinery. The polystyrene plant was built at the same time that Oil built a benzene plant at the refinery. Benzene is the raw material needed by Chemical to produce polystyrene. Chemical's managers believe they can sell 50 million kilograms of polystyrene per year, which is less than full capacity. Following are Chemical's expected revenues and costs for the polystyrene plant (volume is measured using weight in kilograms rather than a liquid measure such as litres):

Per kilogram

Selling price $0.30

Benzene (from Oil) ?

Variable production costs 0.03

Fixed production cost 0.05

Oil can operate at full capacity and sell all the gasoline it produces. Following are Oil's expected revenues and costs for the production of gasoline:

Per kilogram

Selling price $0.16

Crude oil 0.06

Variable production costs 0.02

Fixed production costs 0.07

For every kilogram of benzene that Oil produces, it will forgo selling a kilogram of gasoline. However, 50 million kilograms per year would be only a small portion of the total volume at the refinery. Following are Oil's expected revenues and costs for the production of benzene(these costs include the costs of refining the crude oil):

Per kilogram

Selling price(to Chemical) $?

Crude oil 0.06

Variable production costs 0.04

Fixed production costs 0.09

Required:

1.On a company-wide basis, should Adams International produce polystyrene this year? Why or why not?

2. What is the maximum price that Chemical's managers would be willing to pay for benzene?

3. Would Chemical's managers be willing to pay the maximum transfer price calculated in part 2? Why or why not?

4. What is the minimum price that Oil's managers would be willing to receive for Benzene?

5. What transfer price might be fair to the managers of both divisions? Explain