Question

Case 11A-7 Transfer Pricing; Divisional Performance [LO11-5] Weller Industries is a decentralized organization with six divisions. The company’s Electrical Division produces a variety of electrical items, including an X52 electrical fitting. The Electrical Division (which is operating at capacity) sells this fitting to its regular customers for $8.10 each; the fitting has a variable manufacturing cost of $4.58. The company’s Brake Division has asked the Electrical Division to supply it with a large quantity of X52 fittings for only $6.10 each. The Brake Division, which is operating at 50% of capacity, will put the fitting into a brake unit that it will produce and sell to a large commercial airline manufacturer. The cost of the brake unit being built by the Brake Division follows: Purchased parts (from outside vendors) $ 23.20 Electrical fitting X52 6.10 Other variable costs 14.32 Fixed overhead and administration 8.30 Total cost per brake unit $ 51.92 Although the $6.10 price for the X52 fitting represents a substantial discount from the regular $8.10 price, the manager of the Brake Division believes the price concession is necessary if his division is to get the contract for the airplane brake units. He has heard “through the grapevine” that the airplane manufacturer plans to reject his bid if it is more than $53 per brake unit. Thus, if the Brake Division is forced to pay the regular $8.10 price for the X52 fitting, it will either not get the contract or it will suffer a substantial loss at a time when it is already operating at only 50% of capacity. The manager of the Brake Division argues that the price concession is imperative to the well-being of both his division and the company as a whole. Weller Industries uses return on investment (ROI) to measure divisional performance. Required: 1. Assume that you are the manager of the Electrical Division. a. What is the lowest acceptable transfer price for the Electrical Division? b. Would you supply the X52 fitting to the Brake Division for $6.10 each as requested? 2. Calculate the net positive effect on the company's profit per brake unit the Electrical Division to supply the fittings to the Brake Division and if the airplane brakes can be sold for $53? 3. In principle, within what range would that transfer price lie?

Answer 1

1

a

Since Electric division is operating at capacity the lowest acceptable price would the selling price to outsiders ie $8.10

b

The manager of electric division would not agree to transfer price of $6.10 as there would be a loss of ($8.10-$6.10) ie

$2 on each unit sold to Brake Division

2

Selling Price

$53

Purchased Parts from outside vendors

($23.20)

Other Variable Costs

($14.32)

Loss of Revenue from sale of fittings to outsiders

($8.10)

Net Positive effect on the company profit per brake unit

$7.38

Fixed Cost is irrelevant for decision making

3

Electric division manager would not agree for a transfer price of less than $8.10 as it will reduce the return on Investment

Brake Division may not agree for a price of more than $8.10 as it may be available in market at same price .

Brake and Electric division can agree to any price between $8.10-($8.10+$7.38) $15.48 as it will increase return on investment

of both the departments