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			$	21
Expenses:
Variable	$	12
Fixed (based on a capacity of 97,000 tons per year)		6		18
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 $21 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 $21 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)–(6) below, assume that the Pulp Division is currently selling only 57,000 tons of pulp each year to outside customers at the stated $21 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-a. Suppose the Carton Division’s outside supplier drops its price (net of the purchase discount) to only $17 per ton. Should the Pulp Division meet this price?

4-b. If the Pulp Division does not meet the $17 price, what will be the effect on the profits of the company as a whole?

5. Refer to (4) above. If the Pulp Division refuses to meet the $17 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) 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 $21 per ton. What will be the effect on the profits of the company as a whole?

Answer 1

Part 1

Pulp Division can sell all its produce to outside customer. Hence, the minimum transfer price shall be the selling price to outside customers i.e. $21. However, Carton Division is purchasing the material at $18.90 (i.e, $21 at a discount of 10%). Hence, the maximum price that Carton division will be ready to pay shall be the current purchase cost i.e. $18.90

Therefore, there will be no acceptable range of transfer price.

The managers will not agree to transfer 32,000 tons of pulp next year.

Part 2

If Pulp division meets the price that the Carton division is currently paying to its supplier i.e. $18.90, the profit of pulp division will decrease by $67,200 ($2.1 * 32,000 tons).

However, the profits of Carton division will remain unaffected and the profits of the company will be reduced by $67,200 on an overall basis.

Part 3

The Pulp division has a spare capacity of 40,000 tons (97,000-57,000). Hence, pulp division can transfer the spare capacity at the variable cost of production. Hence, Pulp division can transfer 32,000 units at a minimum transfer price of $12.

Carton Division is purchasing the material at $18.90 (i.e, $21 at a discount of 10%). Hence, the maximum price that Carton division will be ready to pay shall be the current purchase cost i.e. $18.90. Therefore, the acceptable transfer price range shall be $12 to $18.90. Managers are likely to voluntarily agree on the transfer price of 32,000 tons for the next year.

Part 4a

If the supplier drops its price to $17 per ton, the Pulp division can meet this price because the minimum price of transfer is $12.

Part 4b

If Pulp division does not meet the $17 price, the profit of the company as a whole will be reduced by $160,000 [($17 - $12) * 32,000 units]

Part 5

Purchasing by the Carton division at a higher price from Pulp division will not affect the overall profit of the Company because on one side, it will increase the profit of the Pulp division and on the other side, increase the cost of purchases of Carton division with an equal amount.

Part 6

If the Carton division will have to purchase 32,000 units from Pulp division at a price of $21, then profit to Pulp division will be $9 per ton ($21 - $12) and loss to Carton division will be $4 per ton ($21 - $17). Hence overall benefit to company on transfer is $5 per ton ($9 - $4).

Therefore, overall profit of the company will increase by $160,000 (32,000 units @$5 per unit)