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			$	22
Expenses:
Variable	$	12
Fixed (based on a capacity of 95,000 tons per year)		6		18
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 31,000 tons of pulp per year from a supplier at a cost of $22 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 $22 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 31,000 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 31,000 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 54,000 tons of pulp each year to outside customers at the stated $22 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 31,000 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). 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). Assume that due to inflexible management policies, the Carton Division is required to purchase 31,000 tons of pulp each year from the Pulp Division at $22 per ton. What will be the effect on the profits of the company as a whole?

Answer 1

1.)

• The lowest acceptable transfer price from the perspective of the Pulp Division is $22.00. If Pulp Division can sell all of its pulp to outside customers for $22 per ton, lowest acceptable transfer price from the perspective of the Pulp Division is selling price i.e. $22 per ton.
• Highest acceptable transfer price from the perspective of the Carton Division = $22 - $22*10% = $19.80 per ton
• Range of acceptable transfer prices (if any) between the two divisions - Range of acceptable transfer price cannot be established as lowest acceptable transfer price for pulp division is higher than highest acceptable transfer price of Carton division.

Therefore, Range: 19.80 ≤ transfer price ≤22

• Manager of Pulp and carton division is not likely to voluntarily agree to a transfer price for 31,000 tons of pulp next year.

2.)

Profits of the Pulp Division will decrease by (2.20*31000)	$68,200
Profits of the Carton Division will remains unchanged by	0
Profits of the company as a whole will decrease by	$68,200

3.)

Lowest acceptable transfer price formula:

Transfer price ≥ Variable cost +( Total contribution margin on lost sales per unit/ Number of units transferred) = 12+((0) /54000) = $12

Maximum transfer price formula: Transferprice ≤ Cost of buying from outside supplier = $22 a ton less a 10% quantity discount of $2.20 = $19.80

Range: 12 ≤ transfer price ≤19.80

Yes, managers are likely to agree between price range.

4-a.) Yes Pulp division should meet this price because it is in range.

4-b.)

Effect on profits of the company is equal to loss of $5 ($17-$12) per ton

=31,000* $5 = loss of $155,000

i.e. profits will reduce by $155,000

5.)Yes, it will be good for company as whole even Cartons division purchases at higher price than $17

6.)

Company's profits will increase by $155,000 =31000*(17-12)

Because company will save $ 5 per ton as whole.