Question

XYC Inc, a major pest to the tomato crop, are now being controlled by toxic pesticides. The firm ABC invested $5 million in R&D over the last five years to produce a genetically engineered, patented microbe, AK-47, which controls tomato beetles in an environmentally safe way. ABC built a plant with capacity to produce 10,000 pounds of AK-47 per month. The plant cost $12 million and has a 10-year life. AK-47 has a variable cost of $3 per pound. Fixed costs are $50,000 per month for such costs as plant management, insurance, taxes, and security. Plant depreciation is not included in the $50,000 fixed cost. ABC evaluates the plant as an autonomous profit center – like it treats its other divisions.

The plant is currently selling 8,000 pounds of AK-47 per month to tomato farmers for $30 per pound. Another division of ABC, Get-a-Life, wants to secure 1,000 pounds per month of AK-47 that it will process further into a consumer product, Not-so-safe, for gardeners. Get-a-Life is willing to pay an internal transfer price of $5 per pound. Get-a-Life will incur an additional $4 of variable cost per pound of AK-47 in packaging and reducing the potency of AK-47 to make Not-so-safe more appropriate for home gardeners. Not-so-safe will sell for $20 per pound.

Would it be beneficial for the firm for the transfer to take place? Provide quantitative justification along with qualitative interpretations.?

Does your answer to part 1 (re: whether this transfer is beneficial for the firm) depend on the transfer price? Provide a specific explanation for your conclusion, whether “yes” or “no”?.

Discuss the suggested internal transfer price of $5 per pound of AK-47. Specifically, is the plant likely to accept this price and why/why not?

After deciding to use a transfer price of $5 per pound for 1,000 pounds per month of AK-47, the plant receives new orders from tomato farmers for 2,000 additional pounds of AK-47 at $30 per pound. Outline: a) the various options facing the firm, and b) a recommended course of action. Hint: for full credit, there are 2 options that you should compare quantitatively and analyze to support your recommended course of action.

Answer 1

Statement showing contribution of firm if transfer is made :-

Contribution from AK-47 & get -a-life

Cintribution from ak-47 Sales: outside (8000x30). 240000 Internally (1000x5) . 5000	245000
Less : variable cost (9000x3)	(27000)
Contribution from AK-47	218000
Contribution by get-a-life {1000x(20-5-4) Total contribution of company as a whole	11000 $229000

Contribution if no internal transfer is made

Contribution from ak-47 :
Sales (8000x30)	240000
Less : variable cost (8000x3)	24000
contribution from ak-47	216000
Contribution from get - a - life Total contribution	0 216000

We can see that total contribution in case internal transfer is made will be $229000

And total contrubution in case transfer is not made will be $216000.

Therefore we should make internal transfer.

Qualitative interpretation :- note that total variable cost incurred for producing 1000 units and then transferring it internally will be $3 whereas we are able to see it outside @$20 after incurring $4 further cost . So we can get $11 (20-11-9) per pound by internally transferring. Although fixed cost will continue to occur irrespective of the fact that we produce for internal transfer or not. That is why it is beneficial to produce abd internally transfer.

2. No, answer to 1 do not depends on transfer price. Rather it depends upon contribution from get-a-life from it's ultimate sale.

3 . In such a situation we have two options :-

Option 1 instead of internally transferring we sale to Farmers for 2000 additional pounds

Option 2 Internally transferring 1000 pounds to get-a-life (in such a case we cannot undertake whole 2000 pounds order since orders cannot be taken in parts).

Option 2 . We have already alanlyzed and got contribution of the company as whole amounting to $229000.

Option 1 . Statement showing contribution

Contribution from AK-47
Sales (10000x30)	300000
Less : variable cost (10000x3)	30000
Contribution from AK-47	$27000
Contribution from grt-a-life	0
Overall contribution	$270000

Contribution .in case of option 1 is more. Therefore, we should sell 2000 pounds to farmers instead of internally transferring 1000 pounds to get-a-life.

Note :- we have ignore fixed cost altogether in the whole analysis. It is because it tends to remain fixed in each and every case . Thus, it is irrelevant in decision making.