QUESTION TWO

Basic Transfer Pricing

In Cases 1 to 3 below, assume that Division A has a product that can be sold either to Division B of the same company or to outside customers. The man agers of both divisions a re evaluated based on her own division's return o n investment (ROI). The managers are free to decide if they will participate in any internal transfers. All transfer prices a re negotiated. Treat each case independently.

Case

1234

Division A:

Capacity in units

50,000

300,000

100,000

200,000

Number of units now being sold to outside customers

50,000

300,000

75,000

200,000

Selling price per unit to outside customers

$100

$40

$60

$45

Variable costs per unit

$63

$19

$35

$30

Fixed costs per unit (based on capacity)

$25

$8

$17

$6

Division B:

Number of units needed annually

10,000

70,000

20,000

60,000

Purchase price now being paid to an

outside supplier

$92

$39

$60*

0

*Before any purchase discount.

Required:

1. Refer to Case 1. A study has indicated that Division A can avoid $5 per unit in variable costs on any sales to Division B. Will the managers agree to a transfer and if so, within what range will the transfer price be? Explain.

2. Refer to Case 2. Assume that Division A can avoid $4 per unit in variable costs on any sales to Division B.

a.Would you expect any disagreement between the two divisional managers over what the transfer price should be? Explain.

b.Assume that Division A offers to sell 70,000 units to Division B for $38 per unit and that Division B refuses this price. What will be the loss in potential profits for the company as a whole?

3.Refer to Case 3. Assume that Division B is now receiving a 5% price discount from the outside supplier.

a.Will the managers agree to a transfer? If so, within what range will the transfer price be?

b.Assume that Division B offers to purchase 20,000 units from Division A at $52 per unit. If Division A accepts this price, would you expect its ROI to increase, decrease, or remain unchanged? Why?