Transfer Pricing Exercise

Transfer Pricing Problems (1) Two of the divisions of the Chambers Corporation are the Intermediate Division and the Final Division. The Intermediate Division produces three products: A,B, and C. Normally these products are sold both to outside customers and to the Final Division. The Final Division uses Products A, B, and C in manufacturing Products X,Y, and Z, respectively. In recent weeks, the supply of Products A, B, and C has tightened to such an extent that the Final Division has been operating considerably below capacity because of the lack of these products. Consequently, the Intermediate Division has been told to sell all its products to the Final Division. The financial facts about these products are as follows: Intermediate Division

Transfer price Variable manufacturing cost

Product A $ 10.00 3.00

Product B $ 10.00 6.00

Product C $ 15.00 5.00

Contribution per unit Fixed costs (total)

$ 7.00 $50,000

$ 4.00 $100,000

$ 10.00 $75,000

The Intermediate Division has a monthly capacity of 50,000 units. The processing constraints are such that capacity production can be obtained only by producing at least 10,000 units of each product. The remaining capacity can be used to produce 20,000 units of any combination of the three products. The Intermediate Division cannot exceed the capacity of 50,000 units. The Final Division has sufficient capacity to produce about 40 percent more than it is now producing because the availability of Products A, B, and C is limiting production. Also, the Final Division can sell all the products that it can produce at the prices indicated above.

Selling price Variable cost: Inside purchases Other variable costs Total variable cost Contribution per unit Fixed costs (total) Questions

Final Division Product X $ 28.00

Product Y $ 30.00

Product Z $ 30.00

10.00 5.00

10.00 5.00

15.00 8.00

$ 15.00 $ 13.00 $ 100,000

$ 15.00 $ 15.00 $ 100,000

$ 23.00 $ 7.00 $200,000

(a) (b) (c)

If you were the manager of the Intermediate Division, what products would you sell to the Final Division? What is the amount of profit that you would earn on these sales? If you were the manager of the Final Division, what products would you order from the Intermediate Division, assuming that the Intermediate Division must sell all its production to you? What profits would you earn? What production pattern optimizes total company profit? How does this affect the profits of the Intermediate Division? If you were the executive vice president of Chambers and prescribed this optimum pattern, what, if anything, would you do about the distribution of profits between the two divisions?

(2) How, if at all, would your answers to Problem (1) change if there were no outside markets for Products A, B, or C? (3) The Chambers Company has determined that capacity can be increased in excess of 50,000 units, but these increases require an out-of-pocket cost penalty. These penalties are as follows: Cost Penalty Volume in Excess of Present Capacity (unit) 1,000 2,000 3,000 4,000

Product A $10,000 25,000 50,000 80,000

Product B $12,000 24,000 50,000 80,000

Product C $10,000 20,000 35,000 50,000

Each of these increases is independent – that is, increases in the production of Product A do not affect the costs of increasing the production of Product B. Changes can be made only in quantities of 100 units, with a maximum increase of 4,000 units for each product. All other conditions are as stated in Problem 5. Questions (a)

What would be the Intermediate Division’s production pattern, assuming that it can charge all penalty costs to the Final Division? (b) The Final Division’s optimum production pattern, assuming that it is required to accept the penalty costs? (c) The optimum Company production pattern? (4) How would your answer differ if the Intermediate Division had no outside markets for Products A, B, and C?