Question

Appropriate Transfer Prices: Opportunity Costs
Plains Peanut Butter Company recently acquired a peanut-processing company that has a normal annual capacity of 4,000,000 pounds and that sold 2,800,000 pounds last year at a price of $2.00 per pound. The purpose of the acquisition is to furnish peanuts for the peanut butter plant, which needs 1,600,000 pounds of peanuts per year. It has been purchasing peanuts from suppliers at the market price. Production costs per pound of the peanut-processing company are as follows:

Direct materials	$0.50
Direct labor	0.24
Variable overhead	0.12
Fixed overhead at normal capacity	0.22
Total	$1.08

Management is trying to decide what transfer price to use for sales from the newly acquired Peanut Division to the Peanut Butter Division. The manager of the Peanut Division argues that $2.00, the market price, is appropriate. The manager of the Peanut Butter Division argues that the cost price of $1.08 (or perhaps even less) should be used since fixed overhead costs should be recomputed. Any output of the Peanut Division up to 2,800,000 pounds that is not sold to the Peanut Butter Division could be sold to regular customers at $2.00 per pound.

(a) Compute the annual gross profit for the Peanut Division using a transfer price of $2.00.
$Answer

(b) Compute the annual gross profit for the Peanut Division using a transfer price of $1.08.
$Answer

(c) Which of the following is least likely to motivate the manager to take actions that will maximize corporate profits?

a.Set the transfer price at 2.00 for all transfers.

b.Set the transfer price at .86 for all transfers.

c.Set the transfer price at .86 for the first 1,200,000 lbs. transferred.

d.Set the transfer price at .86 for the first 1,200,000 lbs. transferred, and at 2.00 for the next 400,000 lbs. transferred.

e.None of the above.

Answer 1

Solution

Plains Peanut Butter Company

1. Computation of the annual gross profit for the Peanut Division using a transfer price of $2:

Annual gross profit = $4,472,000

Computations are as follows,

Transfer price	$2.00
Direct material	$0.50
Direct labor	$0.24
variable overhead	$0.12
total variable cost	$0.86
Contribution margin	$1.14
peanuts needed for Plains	1,600,000 pounds
Contribution margin	$1,824,000
Contribution margin from outside sale	$2,736,000	2,400,000 x $1.14
Total contribution margin	$4,560,000
Fixed cost	$88,000
Gross profit	$4,472,000

1. Total normal capacity = 4,000,000 pounds

Transferred = 1,600,000

Remaining to outside customers = 2,400,000

1. fixed cost = $0.22 x 4,000,000 = $88,000
2. Since the transfer price and price to outside customers is same at $2, the contribution margin per pound is same at $1.14

1. Computation of annual gross profit for Peanut division using a transfer price of $1.08:

Total gross profit = $3,000,000

Computations are as follows,

Transfer price	$1.08
Direct material	$0.50
Direct labor	$0.24
variable overhead	$0.12
total variable cost	$0.86
Contribution margin	$0.22
peanuts needed for Plains	1,600,000 pounds
Contribution margin	$352,000
Contribution margin from outside sale	$2,736,000	2,400,000 x($2.00 - $0.86 = $1.14)
Total contribution margin	$3,088,000
Fixed cost	$88,000
Gross profit	$3,000,000

The transfer price= $1.08

Contribution margin = 1.08 – 0.86 = $0.22

Total contribution margin for 1,600,000 pounds = $0.22 x 1,600,000 = $352,000

Sales price ,outside customers = $2.00

Contribution margin = 2.00 – 0.86 = $1.14

Contribution margin for 2,400,000 (4,000,000 – 1,600,000) = $1.14 x 2,400,000 = $3,088,000

Fixed cost = $0.22 x 4,000,000 = $88,000

1. The manager of the Peanut Butter Division would least likely to be motivated to take actions that would maximize corporate profits, would be option a.

Option a. – set the transfer price at $2.00 for all transfers

When the transfer price is set at $2.00 for all transfers, the price is same as market price.

Also, the price fails to avoid the fixed cost portion of $0.22 per pound.

The transfer price of $2.00 would nullify the entire efforts involved in acquiring the Peanut-Processing Company, as the company is already purchasing peanuts from outside suppliers at that price.