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			$	24
Expenses:
Variable	$	15
Fixed (based on a capacity of 98,000 tons per year)		6		21
Net operating income			$	3

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 32,000 tons of pulp per year from a supplier at a cost of $24 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.

Required:

For (1) and (2) below, assume the Pulp Division can sell all of its pulp to outside customers for $24 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 32,000 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 32,000 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)–(5) below, assume that the Pulp Division is currently selling only 58,000 tons of pulp each year to outside customers at the stated $24 price.

3. 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 32,000 tons of pulp next year?

4. If the Pulp Division does not meet the $20 price, what will be the effect on the profits of the company as a whole?

5. Refer to (4) above. Assume that due to inflexible management policies, the Carton Division is required to purchase 32,000 tons of pulp each year from the Pulp Division at $24 per ton. What will be the effect on the profits of the company as a whole?

Answer 1

Assuming the Pulp Division can sell all of its pulp to outside customers for $24 per ton. The pulp division will transfer the pulp at market price because it has no excess capacity and hence has to loose normal sales in order to transfer on which it is going to loose the contribution margin .

1). Lowest acceptable transfer price from the perspective of the Pulp Division is $24 per ton.
Highest acceptable transfer price from the perspective of the Carton Division = $24 - ($24 * 10%) = $21.6
There is no range of tranfer price because lower acceptable price of Pulp division is higher than the highest acceptable price of carton division.
Managers of the Carton and Pulp Divisions are not likely to voluntarily agree to a transfer price for 32,000 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 32,000 tons of pulp to the Carton Division each year.
Effect on profit of Pulp division = ($21.6 - $24) * 32000 ton = $ (76,800) i.e loss
Effect on profit of Carton division = No Effect because its purchase price is same.
Effect on profit on whole company = $ (76,800) i.e loss

Assuming that the Pulp Division is currently selling only 58,000 tons of pulp each year to outside customers at the stated $24 price. Hence for using excess capacity, the relevant cost of internal transfers of pulp is variable cost because fixed cost is already been charged on normal orders.
3). Lowest acceptable transfer price from the perspective of the Pulp Division is $15 per ton.
Highest acceptable transfer price from the perspective of the Carton Division = $24 - ($24 * 10%) = $21.6
Range of transfer price = $15 to $21.6 per ton.
Managers of the Carton and Pulp Divisions are likely to voluntarily agree to a transfer price for 32,000 tons of pulp next year because there is gap in minimum and maximum acceptable transfer price for both division.

4). If the Pulp Division does not meet the $20 price then the carton division will purchase from outside where cost is $21.6 per ton while pulp division can make it at lowest of $15 per ton. Hence not agreeing on transfer price will result in loss of
= $21.6 - $15
= $6.6 per ton to the company as a whole.
Total loss to the company = 32000 ton * $6.6 = $211,200

5). Profits to Pulp Division = ($24 - $15) * 32000 ton = $288,000
Loss to Carton Division = ($24 - $21.6) * 32000 ton = $76,800
Effect on profit of Company as whole = Profit of Pulp division - Loss of Carton Division
= $288,000 - $76,800
= $211,200 i.e. Incremental Profit.