Question

Baxter Corp is a diversified manufacturing company with a decentralized management structure. Each division is treated as a profit center. One of these divisions is Duke Processing, which produces a variety of products at a single plant. Duke operates below capacity. Duke’s biggest customer for a major product, XB42, is Eastwood Industries, another division of Baxter Corp. 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. Eastwood has been paying $1,075/unit, with the discount reflecting lower transaction costs for Duke. Eastwood has found another supplier for XB42 at a price of $690/unit. Duke’s president refuses to meet this price, as it is below cost, and she will lose money on the sale.

Discuss: As CEO of Baxter Corp, discuss the factors to be considered in resolving the pricing dispute between Duke and Eastwood.

Answer 1

In the Books of Baxter Corp.

This problem relates to transfer pricing decision.

For Duke, the variable cost to produce the product shall be :

DM = 310; DL = 80; Variable OH = 450*40% = 180.

Therefore, its total variable cost shall be : 310+80+180 = 570$.

Fixed cost shall be incurred and it will not get avoided.

The transfer price to division Duke is $ 1075 per unit, whereas, its external sales be at $ 1120 per unit.

Its major customer is another division Eastwood itself. Hence, the major profit that the Duke division earns is through its product XB42 's sale to Eastwood division.

The Eastwood division has found another supplier supplying the same product at $ 690 per unit.

If division Eastwood purchases the component from outside at 690$ per unit, then the incremental loss to the organisation i.e. Baxter Corp. shall be : 30000 units * (690-570) = 30000 * 120 = 3600000.

Therefore, in the absence of any other information regarding Eastwood division & considering the facts given in the question, if Eastwood purchases the product at 690 there shall be an incremental loss to Baxter Corp.

Hence, it is not advisable to buy from outside supplier.