Question

Hrubec Products, Inc., operates a Pulp Division that manufactures wood pulp for use in the production of various paper goods. Revenue and costs associated with a ton of pulp follow:

Selling price			$	23
Expenses:
Variable	$	13
Fixed (based on a capacity of 98,000 tons per year)		6		19
Net operating income			$	4

Hrubec Products has just acquired a small company that manufactures paper cartons. This company will be treated as a division of Hrubec with full profit responsibility. The newly formed Carton Division is currently purchasing 31,000 tons of pulp per year from a supplier at a cost of $23 per ton, less a 10% purchase discount. Hrubec’s president is anxious for the Carton Division to begin purchasing its pulp from the Pulp Division if an acceptable transfer price can be worked out.

For (1) and (2) below, assume the Pulp Division can sell all of its pulp to outside customers for $23 per ton.

1. What is the lowest acceptable transfer price from the perspective of the Pulp Division? What is the highest acceptable transfer price from the perspective of the Carton Division? What is the range of acceptable transfer prices (if any) between the two divisions? Are the managers of the Carton and Pulp Divisions likely to voluntarily agree to a transfer price for 31,000 tons of pulp next year?

2. If the Pulp Division meets the price that the Carton Division is currently paying to its supplier and sells 31,000 tons of pulp to the Carton Division each year, what will be the effect on the profits of the Pulp Division, the Carton Division, and the company as a whole?

For (3)–(6) below, assume that the Pulp Division is currently selling only 59,000 tons of pulp each year to outside customers at the stated $23 price.

4-a. Suppose the Carton Division’s outside supplier drops its price (net of the purchase discount) to only $18 per ton. Should the Pulp Division meet this price?

4-b. If the Pulp Division does not meet the $18 price, what will be the effect on the profits of the company as a whole?

6. Refer to (4) above. Assume that due to inflexible management policies, the Carton Division is required to purchase 31,000 tons of pulp each year from the Pulp Division at $23 per ton. What will be the effect on the profits of the company as a whole?

Answer 1

Solution 1:

If Pulp Division can sell all of its pulp to outside customers for $23 per ton, lowest acceptable transfer price from the perspective of the Pulp Division is selling price i.e. $23 per ton.

Highest acceptable transfer price from the perspective of the Carton Division = $23 - $23*10% = $20.70 per ton

Range of acceptable transfer prices (if any) between the two divisions - Range of acceptable transfer price cannot be established as lowest acceptable transfer price for pulp division is higher than highest acceptable transfer price of Carton division.

Manager of Pulp and carton division is not likely to voluntarily agree to a transfer price for 31,000 tons of pulp next year.

Solution 2:

If the Pulp Division meets the price that the Carton Division is currently paying to its supplier and sells 31,000 tons of pulp to the Carton Division each year, then effect on profit of pulp division = ($20.70 - $23) * 31000 = $71,300 - Decrease in profit.

There will be no impact on profit of carton division as he will get pulp at the same rate that it buy from outside supplier.

As pulp division is able to sell all the quantities to outside customer, then transfer to carton division will result in loss of sale to regular customer, therefore profit of the company as a whole also decreases by $71,300.

Solution 3:

If Pulp Division is currently selling only 59,000 tons of pulp each year to outside customers at the stated $23 price, it means division is having spare capacity of 39000 tons of pulp.

Lowest acceptable transfer price from the perspective of the Pulp Division = Variable cost per ton

= $13

Highest acceptable transfer price from the perspective of the Carton Division = $23 - $23*10% = $20.70 per ton

Range of acceptable transfer prices (if any) between the two divisions = $13 to $20.70

Yes, the managers of the Carton and Pulp Divisions likely to voluntarily agree to a transfer price for 31,000 tons of pulp next year

Solution 4a:

If Carton Division’s outside supplier drops its price (net of the purchase discount) to only $18 per ton, pulp division can meet the price as its additional cost per ton is only $13 per ton.

Solution 4b:

If the Pulp Division does not meet the $18 price, the effect on the profits of the company as a whole = ($18 - $13)* 31000 = $155,000 decrease.

The profit company as a whole will decrease by $155,000 as carton division will purchase pulp from outside market at higher cost.

Solution 6:

If Carton Division is required to purchase 31,000 tons of pulp each year from the Pulp Division at $23 per ton, then company will save $5 per ton by making the pulp for carton division.

Effect on profit of company as a whole = ($18 - $13) * 31000 = $155,000 increase in profit