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 101,000 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 29,000 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 29,000 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 29,000 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 60,000 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 29,000 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 29,000 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

1. Lowest acceptable tranfer price to pulp division = $21 (since operating at 100% capacity)

Highest Acceptable tranfer price for Carton Division = $18.9 (the price at which it is currently purchasing from outside)

There’s no range of acceptable tranfer prices between the two.

The managers of both the divisions are not likely to agree to a transfer price of 29000 tons of pulp next year

2.Profits of pulp division would reduce by 2.1*29000 = $60,900

There will be no effect on the profits of carton division

Company’s profits will come down by $60,900

3.Lowest acceptable tranfer price to pulp division = Variable cost per unit i.e. $12 (since spare capacity exists)

Highest Acceptable Transfer price by Carton Division = $18.9 (the price at which it is currently purchasing from outside)

Range of Acceptable tranfer prices = $12-$18.9

Yes, the managers of both the divisions are likely to agree to a transfer price of 29000 tons of pulp next year

4a. Yes, the pulp division should meet this price since the minimum price acceptable by pulp division is $12

4b. The company will incur additional expenses of $5 per ton of pulp, hence reducing the profits of the company by $5*29000 = $145,000

5.The Carton Division can purchase from the Pulp Division at a higher price for the benefit of the company as a whole.

6. Additional contribution to pulp division on 29000 units = 29000*(21-12) = $261,000

Loss to Carton Division = 29000*(21-17) = $116,000

Hence, Overall profits of the company shall increase by $145,000