Question

Poudre Industries is a diversified manufacturing company with a decentralized management structure. Each division is treated as a profit center. One of these divisions is Wellington Processing, which produces a variety of products at a single plant. Wellington operates below capacity. Wellington’s biggest customer for a major product, XB42, is Eaton Industries, another division of Poudre. At the normal production level of 30,000 units, XB42 costs $840 to produce: direct materials, $310; direct labor, $80; overhead, $450). The composition of the overhead cost is 60% fixed and 40% variable. The current selling price of XB42 is $1,120/unit. Eaton has been paying $1,075/unit, with the discount reflecting lower transaction costs for Wellington. Eaton has found another supplier for XB42 at a price of $690/unit. Wellington’s president refuses to meet this price, as it is below cost, and she will lose money on the sale.   Required: As CEO of Poudre, discuss the factors to be considered in resolving the pricing dispute between Wellington and Eaton.

Answer 1

For the selling division, the minimum acceptable transfer price = Variable cost of manufacture per unit + opportunity cost of lost orders per unit = ( Direct Materials + Direct Labor + Variable Overhead ) + Contribution Margin Lost / Number of Units Transferred.

We are told that Wellington Processing, the selling division operates below capacity. In other words, there is ample capacity. Therefore,

The minimum transfer price for the division := $ ( 310 + 80 + 450 x 40%) + $ 0 / Number of units transferred = $ 570.

Therefore, the transfer price would lie between $ 570 and $ 690, since Eaton Industries, the buying division would not now be willing to pay anything beyond $ 690.

Wellington Processing should accept a transfer price above $ 570, as that would generate a contribution margin for absorbing the fixed overheads.

If Eaton Industries decides to buy from the outside supplier, Wellington Processing plant would not only become idle, but the operating profit for the company as a whole will decrease.