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			$	25
Expenses:
Variable	$	15
Fixed (based on a capacity of 96,000 tons per year)		6		21
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 $25 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 $25 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 56,000 tons of pulp each year to outside customers at the stated $25 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 $20 per ton. Should the Pulp Division meet this price?

4-b. If the Pulp Division does not meet the $20 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 $20 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 $25 per ton. What will be the effect on the profits of the company as a whole?

Answer 1

When Pulp division is able to sell all its pulp to outside at $25.

1). Lowest acceptable price from the perspective of pulp division is $25.
Highest acceptable transfer price form the perspective of carton division is $25-10% = $22.5 per ton.
There is no range of transfer prices.
Managers of both the divisions are not likely to voluntarily agree for transfer of pulp.

2). If pulp division meet the price which the carton division paying to outside supplier then it will decrease its profit by $72500 i.e 29000 tons * 2.5 per ton loss.
There is no effect on the profits of carton division.
There is decrease in profits of the company as a whole by $72500

When pulp division is only selling 56000 tons of pulp to outside customers.

3). Lowest acceptable price from the perspective of pulp division is $15 i.e relevant cost, here fixed cost is not taken because it will incur wheather or not this decision is taken, hence sunk.
Highest acceptable transfer price form the perspective of carton division is $25-10% = $22.5 per ton.
Range of tranfer price is from $15 to $22.5
Yes, the managers of both the division are likely to agree to tansfer 29000 pulp during next year.

4 a). If the outside supplier drops its price to $20 per ton. then the pulp division should meets this price because it will give additional profit to pulp division by $5 per ton.

4 b). If pulp division does not meet the price of $20, it will impact its additional profits and also reduces the profits of company as a whole by $5 per ton i.e 29000 ton * $5 = $145000.

5). If pulp division refuses to meet the price of $20, then for the benefit of company as whole, carton division should be required to buy from pulp division even at higher price because it will still contributes to the profit of the company and if not then there is a loss of $145000 same as above.

6).If due to management policies, carton division must buy pulp from pulp division at $25, then there is no impact on the profits of the company as a whole, because the loss of carton division is going to set off against the increase in profits of pulp division and net benefit of $5 will remain on inter division purchases.