Question

Galena Corporation manufactures RD34 in its City Division. This output is sold to the Urban Division as a raw material in the Urban Division's product. The City Division also further processes the RD34 into RD35, and then sells it to other companies.
The City Division's variable costs for the basic ingredient are $15 per unit. The Urban Division's variable costs are $5 per unit in addition to what it pays the City Division. The Urban Division has a capacity of 400,000 units and it can sell everything it produces. The market price for the finished additive is $40 per unit. If the City Division converts the RD34 into RD35, it can receive $25 per unit on the open market, but it incurs an additional $4 per unit for this processing.

Required:

(a) What is the lowest price at which the City Division should be willing to transfer RD34 to the Urban Division, assuming the City Division is notoperating at capacity?
(b) What is the lowest price at which the City Division should be willing to transfer RD34 to the Urban Division, assuming the City Division is operating at capacity?
(c) Ignore parts (a) and (b). Assume that the City Division has a capacity of 500,000 units but can only sell 300,000 on the open market. How many units should the City Division sell externally and how many units should it sell to Urban Division at a transfer price of $20?

Answer 1

A market-based transfer price is based on the fair market value of the good being transferred from the selling division to the buying division. When the selling division does not have excess (idle) capacity, the market price most closely approximates the opportunity cost of the resource. Market price becomes the selling price for the selling department and purchase price for the buying department.

But when the selling division has excess capacity, the variable cost becomes the lowest price at which the selling division shall sell such excess capacity to the buying division.

(a) As the City Division is not operating at capacity that means it has idle capacity, the lowest transfer can be the variable cost to produce RD34 i.e. $15.

(b) As the City Division is operating at capacity that means it does not have idle capacity, the lowest transfer can be the variable cost plus the opportunity cost if the product would have sold in the market.

Opportunity cost if the product would have sold in the market = Selling Price - Variable cost - Additional Expense

Opportunity cost if the product would have sold in the market = $25 - $15- $4 = $6

Therefore, the minimin transfer price = Variable cost + Opportunity cost

= $15 + $6 = $21 per unit

(c)

At transfer price of $20, the City Division will gain $5 ($20-$15) per unit but the benefit, if it would have got if the product was converted into RD35, would have been $6.

Therefore, first, the City Division will like to fulfill the demand of the market as it will yield $1 ($6-$5) more.

Any excess capacity can be sold to the urban division.

In the given case scenario, the City division has the market demand of 500,000 units and external demand of only 300,000 units.

Therefore, the City Division should sell 300,000 units externally and 200,000 units to Urban Division.