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	$	14
Fixed (based on a capacity of 104,000 tons per year)		6		20
Net operating income			$	4

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 27,000 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 27,000 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 27,000 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)–(6) below, assume that the Pulp Division is currently selling only 66,000 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 27,000 tons of pulp next year?

4-a. Suppose the Carton Division’s outside supplier drops its price (net of the purchase discount) to only $19 per ton. Should the Pulp Division meet this price?

4-b. If the Pulp Division does not meet the $19 price, what will be the effect on the profits of the company as a whole?

5. Refer to (4). If the Pulp Division refuses to meet the $19 price, should the Carton Division be required to purchase from the Pulp Division at a higher price for the good of the company as a whole?

6. Refer to (4). Assume that due to inflexible management policies, the Carton Division is required to purchase 27,000 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

1)
a)
The lowest acceptable transfer price from the perspective of the Pulp Division is:
Transfer Price ≥ Variable cost per unit + (Total contribution margin on lost sales/Number of units transferred)
Transfer Price ≥ $14 + (27000 x ($24 - $14/27000	$        24.00
Therefore, the Pulp Division will refuse to transfer at a price less than $23 a ton
b)
The Carton Division can buy pulp from an outside supplier ($24 x (1-10%))	$        21.60
Therefore, the Carton Division would be unwilling to pay more than $21.60 per ton
$21.60 ≥ Transfer Price ≥  $24
c)
NO
The Carton Division won’t pay more than $21.60 and the Pulp Division will not accept less than $24. Thus, there can be no mutually agreeable transfer price and no transfer will take place.
2)
The Pulp Division will have an increase in profits:
Selling price	24
Less variable costs	14
Contribution margin per ton	10
Increased Profits = 27,000 tons × $10 per ton =	270000
The Carton Division will have a decrease in profits
Inside purchase price	24
Outside purchase price	21.6
Increased cost per ton	2.4
Decreased Profits = 27000 tons x $2.40 per Ton	64800
The company as a whole will have an increase in profits:
Increased contribution margin in the Pulp Division	10
Decreased contribution margin in the Carton Division	-2.4
Increased contribution margin per ton	7.6
Increased Profits = 27000 tons x $7.60 per ton	205200