Question

Problem 11A-4 Transfer Price with an Outside Market [LO11-5]

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	$	11
Fixed (based on a capacity of 96,000 tons per year)		6		17
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 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 55,000 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 $16 per ton. Should the Pulp Division meet this price?

4-b. If the Pulp Division does not meet the $16 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 $16 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 transfer price from the perspective of the Pulp Division is $22 per ton. Highest acceptable transfer price from the perspective of the Cartoon Division is $19.8 i.e.($22 x 90%). There is no range of acceptable transfer price. Managers of both Cartoon and Pulp Division will not voluntarily agree to a transfer price for 31,000 tons of pulp next year.

2. Effect on profit of Pulp Division = Decrease of profit $68,200 i.e. ($2.2 x 31,000 tons)

Effect on profit of Cartoon Division = No Effect

Effect on company as a whole = Decrease of profit $68,200 i.e. ($2.2 x 31,000 tons)

3. Lowest acceptable transfer price from the perspective of Pulp Division is $12. Highest acceptable transfer price from the perspective of the cartoon division is $19.8. Acceptable transfer pricing range is $12 to $19.8 . Managers of the Cartoon and Pulp Divisions likely to voluntarily agree to a transfer price for 31,000 tons of pulp next year in the given range of $12 to $19.8.

4-a. Pulp Division can meet this price because its lowest acceptable price is $12 per ton.

4-b. Decrease in profit of company as a whole = $5 x 31,000

...........................................................................= $155,000

5. Yes, Cartoon Division should purchase from the Pulp Division at a higher price for the good of the company as a whole because ultimately the extra cashflows will remain in the company. But if it is purchased from outside than the cashflow will be go outside of the company that results in a loss.

6. Effect on profit of company = Increase in profit ($5 x 31,000) i.e. $155,000

i.e. same as 4-b.