TRANSFER PRICING

Transfer Pricing. Ace Division of Randall Deuce Outsiders

Corporation produces electric motors, 20% of Sales 900,000 8,000,000
which are sold to Deuce Division of Randall Variable (900,000) (3,600,000)
and the remainder to outside customers. The Fixed Cost (300,000) (1,200,000)
company treats its divisions as profit centers Gross Profit (300,000) 3,200,000
and allows division managers to choose their Unit Sales 20,000 20,000
sources of sale and supply. Company policy
requires that all interdivisional sales and Required:
purchases be recorded at a transfer price (1) Assuming that Ace Division desires to maximize its
equal to variable cost. Ace Division's gross profit, should it take on the new customer and
estimated sales and standard cost data for the discontinue its sales to Deuce Division? Support your
year, based on full capacity of 100,000 units, answer by computing the increase or decrease in Ace
follow: Division's gross profit.
(2) Assume instead that Randall Corporation permits
Ace Division has an opportunity to sell to an division managers to negotiate the transfer price. The
outside customer the 20,000 units now com- managers agree on a tentative transfer price of $75
mitted to Deuce Division. The sale price would per unit, to be (AICPA adapted) reduced based on an
equal sharing of the additional gross profit to Ace
be $75 per unit during the current year. Deuce Division resulting from the sale to Deuce of 20,000
Division could purchase its requirements from motors at $75 per unit. What is the actual transfer
an outside supplier at a price of $85 per unit. price?
The Blade Division of Dana Company
produces hardened steel blades. One third Deuce Outsiders
Sales 15,000 40,000
of the Blade Division's output is sold to the
Variable -10,000 -20,000
Lawn Products Division of Dana; the
Fixed Cost -3,000 -6,000
remainder is sold to outside customers.
Gross Profit 2,000 14,000
The Blade Division's estimated sales and
Unit Sales 10,000 20,000
standard cost data for the year follow:
The Lawn Products Division has an Required: Should Dana allow its
opportunity to purchase 10,000 identical
Lawn Products Division to
quality blades from an outside supplier at a
cost of $1.25 per unit on a continuing purchase the blades from the
basis. Assume that the Blade Division outside supplier? Support your
cannot sell any additional products to answer by computing the
outside customers, that the fixed costs increase or decrease in Dana
cannot be reduced, and that no alternative Company operating costs.
use of facilities is available.
LeBlanc Inc. has always been the sole supplier of CAV, a raw material needed by Anderson
Company. LeBlanc has steadily increased the price of CAV to $100 per pound. Badly in need
of a second source, Anderson asked Magnussen to begin producing CAV and thus to
compete with LeBlanc. Anderson and Magnussen are managed as investment centers, and
both are divisions of the Clarkson Company.
Magnussen knew that if it constructed a new, specialized facility, it could make and sell CAV
by incurring variable costs totaling $30 per pound and could be profitable in the long run by
selling CAV at any price above $50 per pound. At a cost of $100,000,000, Magnussen
constructed a facility to make CAV. The facility cannot be used for any other purpose and
has no determinable resale value. The facility has been completed, and its entire
$100,000,000 cost has been paid. It is the largest single investment ever made in any
division of Clarkson Company.
Magnussen decided to delay production of CAV when all the orders from potential buyers of
CAV were canceled in the week before the new facility was scheduled to begin production.
The reason for all the cancellations was that LeBlanc announced a reduction of its price to
$20 per pound effective immediately.
At the next executive meeting at Clarkson headquarters, the general manager of Anderson
Division explained, "Of course we have to buy CAV at the lowest price available to us, or else
we can't be competitive. That's because all our competitors are now getting CAV at $20 and
are slashing the prices on their final product, so we'll be out of business if we have to pay
more than $20 for CAV." Magnussen Division's general manager replied, "There's no way we
can price CAV below $30 in the short run, nor below $50 in the long run."
Required:
(1) What is the short-run, per-pound advantage or disadvantage to Clarkson if Anderson Division
buys CAV from the outside supplier, LeBlanc, for $20 per pound rather than from Magnussen
Division for $50 per pound?
(2) If Anderson indicates it will buy CAV from LeBlanc at $20 per pound, does Clarkson's top
management have any short-run incentive to intervene in the decision and direct Anderson Division
to buy from Magnussen Division?
For the next two parts, suppose LeBlanc changes its per-pound price to $42 and Magnussen sets its
per-pound price at $50.
(3) What is the per-pound advantage or disadvantage to Clarkson if Anderson buys CAV from LeBlanc
for $42 rather than from Magnussen for $50?
(4) If Anderson indicates it will buy CAV from LeBlanc at $42, what short-run incentive is there for
Clarkson's top management to intervene in the decision?
For the next two parts, suppose Clarkson's top management ended the meeting at headquarters by
directing the management teams of Anderson and Magnussen Divisions to ".. ... remain in this
conference room until you have agreed in writing to some arrange- ment by which CAV will be
produced by Magnussen and transferred to Anderson. The arrangement must be acceptable to both
of you, and it must not change your divisions' sta- tus as investment centers. Catered meals, clean
clothing, and anything else you need- except intervention or subsidy from us-will be provided to you
as needed. And keep one thing clearly in mind: if necessary, all of you can be replaced."
(5) In what sense(s) has Clarkson's top management reduced the division's decision-making
autonomy?
(6) In what sense(s) has Clarkson's top management preserved the divisions' decision- making
autonomy?