Transfer Pricing – The Whole Company

ME1 Problem: Transfer Pricing –
The Whole Company
 
The Whole Company is an integrated multidivisional manufacturing firm. Two of itsdivisions, Rod and Champ, are profit centres and their division managers have full responsibilityfor production and sales (both internal and external). Both the Rod and Champ divisionmanagers are evaluated by top management on the basis of total profit.Rod Division is the exclusive producer of a special equipment component called Q-32.Since there is no outside competition for Q-32, the Rod division manager used the results of amarket study together with statistical probability analysis to set the price at $450 per unit of Q-32. At this price, the normal sales and production volume is 21,000 units per year; however, production capacity is 26,000 units per year. Standard production costs for one unit of Q- 32 based on normal production volume are as follows:Direct Materials $175.00Direct Labor 75.00Variable Overhead 50.00Fixed Overhead 90.00Total Unit Production Costs $390.00 Champ Division produces machinery for several large customers on a contractual basis. Ithas recently been approached by a potential customer to produce a specially designed machinewhich would require one unit of Q-32 as its main component. The potential customer hasindicated that it would be willing to sign a long-term contract for 10,400 units of the machine per year at a maximum price of $650 per unit. Although Champ Division has sufficient idle capacityto accommodate the production of this special machine, the division manager is not willing toaccept the contract unless he can negotiate a reasonable transfer price with the Rod divisionmanager for Q- 32. He has calculated that the unit costs to produce the special machine are asfollows:Direct Material other than Q 32 $100.00Direct Laboor 50.00Variable Overhead 35.00Fixed Overhead 50.00Total Unit Production Costs before transfer of Q 32 $235.00REQUIRED:(a) What is the maximum unit transfer price that the Champ division manager should be willingto accept for Q-32 if he wishes to accept the contract for the special machine? Support your answer.(b) What is the minimum unit transfer price that the Rod division manager should be willing toaccept for Q-32? Support your answer.

 
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CMA Ontario
P-134 (c) Assume that Rod Division would be able to sell its capacity of 26,000 units of Q-32 per year in the outside market if the selling price was reduced by 5%. From top management’s point of view, evaluate, considering both quantitative and qualitative factors, whether Rod Divisionshould lower it’s market price or transfer the required units of Q-32 to Champ Division.(d) Assume that top management has decided to impose a dual transfer pricing system for Q-32which would satisfy the Rod division manager and encourage the Champ division manager toaccept the contract for the special machine. Discuss the implications of this decision.
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