Question

Modern Fixtures enterprise makes all types of office chairs. The Standard Division is currently producing 10,000 chairs per year with a maximum capacity of 16,000 chairs. The variable costs assigned to each chair are $250 and annual fixed costs of the division are $800,000. The Standard Division sells its chair to external market for $350. Recently, the Exclusive Division proposed to purchase 6,000 chairs at $220 for its custom office design business. The Standard Division manager refused the order because the price offered for the trade was not lucrative. The Exclusive Division manager argues that the order should be accepted because it will lower the fixed cost per chair from $80 to $50 and will take the division to operate at its capacity, thereby causing operations to be at their most efficient level.

Required:   

1. When cost-based transfer pricing is used to trade between subunits of a large organization, discuss how to avoid making suboptimal decisions.                                            

Answer 1

Sub optimal decision-

The sub optimal decission are mostly take place when, there is divisional transfer of products. Each divisional manager is responsibile for its division performance, hence these divisionla managers will always make the decision while thinking the divisional profits.

In all this process, there are most probable chances of managers to take sub optimal decision, to prtect their divisional profitability.

In the given case the standard divisional manager will never be agree on the proposal of other division because he will have to bear the burden of additional irrecoverable variable cost i.e $180,000 [250-220]*6000. The profit of standard division will be decreased by $180,000 with this decision.

For acheiving the comman objective of company, there should be standard policy for divisional transfer. In order to escape from sub optimal decision, following things must be considered.

1. There should be a fixed salaries to all the divisional managers.
2. There should be minimum performance linked bonus to divisional managers.
3. The management should be designation of personnal to solve the issue pertaining to divisional transfers.
4. The divisonal managers should not be pressurise for unlimited profitablility.
5. There should be periodic meetings amongst all divisional managers to arrive at comman goal of company and for better understanding.
6. Comman goals acheived by personnal must be rewarded by company to promote the comman goal.
7. The incentive should set or provided, considering the divisional performance and at the same time the company's performance as a whole.

Please comment for any additional explanation.

Thanks,