Question

Goal-congruence, taxes, different market conditions. TECA Halifax makes kids’ bicycles. The
frames division makes and paints the frames and supplies them to the assembly division where the bicycles are
assembled. TECA is a successful and profitable corporation that attributes much of its success to its decen-
tralized operating style. Each division manager is compensated on the basis of division operating income.
The assembly division currently acquires all its frames from the frames division. The assembly division
manager could purchase similar frames in the market for $480.
The frames division is currently operating at 80% of its capacity of 4,000 frames (units) and has the fol-
lowing particulars:
Direct materials ($150 per unit × 3,200 units) $480,000
Direct manufacturing labour ($60 per unit × 3,200 units) 192,000
Variable manufacturing overhead costs ($30 per unit × 3,200 units) 96,000
Fixed manufacturing overhead costs 624,000
All the frames division’s 3,200 units are currently transferred to the assembly division. No frames are
sold in the outside market.
The frames division has just received an order for 2,000 units at $450 per frame that would utilize half
the capacity of the plant. The order has to be either taken in full or rejected totally. The order is for a slightly
different frame than what the frames division currently makes but takes the same amount of manufacturing
time. To produce the new frame would require direct materials per unit of $100, direct manufacturing labour
per unit of $48, and variable manufacturing overhead costs per unit of $30.
Instructions
Form groups of two or three students to complete the following requirements.
Required
1. From the viewpoint of TECA Halifax as a whole, should the frames division accept the order for the
2,000 units?
2. What range of transfer prices result in achieving the actions determined to be optimal in requirement
1, if division managers act in a decentralized manner?
3. The manager of the assembly division has proposed a transfer price for the frames equal to the full
cost of the frames including an allocation of overhead costs. The frames division allocates overhead
costs to engines on the basis of the total capacity of the plant used to manufacture the frames.
a. Calculate the transfer price for the frames transferred to the assembly division under this arrangement.
b. Do you think that the transfer price calculated in requirement 3a will result in achieving the actions
determined to be optimal in requirement 1, if division managers act in a decentralized manner?
c. Comment in general on one advantage and one disadvantage of using full costs of the producing
division as the basis for setting transfer prices.

Answer 1

1. From the viewpoint of TECA Halifax as a whole, should the frames division accept the order for the
2,000 units?

Hence, proposal will be accepted from the company point of view.

2. What range of transfer prices result in achieving the actions determined to be optimal in requirement
1, if division managers act in a decentralized manner?

The maximum amount that assembly department can pay for frames to frames department = $480 a price that is available from open market.

The Maximum amount that frames department would demand for their frames would be its Selling price to outside market which is $450.

So the average of this price is acceptable to both the managers which is =$480 + $450 / 2 = $465.

3. The manager of the assembly division has proposed a transfer price for the frames equal to the full
cost of the frames including an allocation of overhead costs. The frames division allocates overhead
costs to engines on the basis of the total capacity of the plant used to manufacture the frames.

a. Calculate the transfer price for the frames transferred to the assembly division under this arrangement.

frames department would demand for their frames would be its cost to manufacture.

which is $150 + $60 + $30 + [$624,000 / 4,000 units] = $396.

b. Do you think that the transfer price calculated in requirement 3a will result in achieving the actions
determined to be optimal in requirement 1, if division managers act in a decentralized manner?

No, because the frames division will not earn any profit from the frames supplied to the assembly department and hence will not be eligible for the incentives based on the profit of the division made.

c. Comment in general on one advantage and one disadvantage of using full costs of the producing
division as the basis for setting transfer prices.

Advantage: It helps to take the optimal deciesions by the centralised managers on the basis of transfer pricing that valued at full cost.

Disadvantage: The managers of particular departments are not interested in minimizing the costs if there is no advantage to them.