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			$	23
Expenses:
Variable	$	14
Fixed (based on a capacity of 105,000 tons per year)		6		20
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 32,000 tons of pulp per year from a supplier at a cost of $23 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) below, assume the Pulp Division can sell all of its pulp to outside customers for $23 per ton.

1. If the Pulp Division meets the price that the Carton Division is currently paying to its supplier and sells 32,000 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 (2)–(4) below, assume that the Pulp Division is currently selling only 63,000 tons of pulp each year to outside customers at the stated $23 price.

2. 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 32,000 tons of pulp next year?

3. If the Pulp Division does not meet the $19 price, what will be the effect on the profits of the company as a whole?

4. Refer to (3) above. Assume that due to inflexible management policies, the Carton Division is required to purchase 32,000 tons of pulp each year from the Pulp Division at $23 per ton. What will be the effect on the profits of the company as a whole?

Answer 1

Solution 1:

For Part 1, it has been assumed that Pulp division can sell all of its pulp to outside customers at $23 per ton. It means Pulp division is operating at full capacity.

Currently. Carton division is buying pulp at a discount rate of 10% on $23. Net price per ton being paid by Carton Division is $20.7 ($23 minus 10%).

If Pulp division supplies pulp at $20.7 per ton, it will incur a reduction in profit of $2.3 per ton since it is getting $23 per ton from outside market. Since Pulp division will supply 32,000 tons of pulp to carton division, Pulp division will incur a reduction in profit of $73,600.

Carton division will be getting the pulp at same price, hence it will not affect its profits.

For the Company on overall level, the profit will be reduced by $73,600 since Pulp division will be facing a reduction in profit of $73,600.

For Solution 2-4, we are assuming that Pulp division can sell only 63,000 tons of pulp each year outside at price of $23 per ton.

Solution 2:

It should be remembered that Fixed Cost in total for Pulp division will remain same whether it supplies to Carton division or not.

Lowest Acceptable Transfer Price for Pulp Division: It would be equal to the variable cost per ton being incurred by the Pulp Division. Currently Pulp Division is incurring $14 as variable cost per ton, hence it will charge a minimum price of $448,000 (32,000 * 14).

Highest acceptable transfer price from the perspective of the Carton Division: Carton division will be ready to pay a maximum price of price equal to the market price at which it is already getting Pulp. As stated in Solution 1, it is getting pulp at rate of $20.7 per ton hence it will pay a maximum of $662,400 (32,000 * 20.7).

Range of Acceptable transfer price per ton: $14 - $20.7

Yes the managers are likely to voluntarily agree to a transfer price for 32,000 tons of pulp next year since the range is acceptable by both the divisions and hence beneficial for both.

Solution 3:

If the Pulp division doesn’t agree on $19 per ton, Carton division will continue to buy 32,000 tons of pulp from outside at price of $20.7. Since Carton Division will be buying at the same price, there would not be any effect of Profit on Company level as whole.

Company will have same profits as of earlier if there is no transfer since Carton Division will continue to buy at the same price from outside.

Solution 4:

If the Carton division has to buy pulp at rate of $23 per ton from Pulp Division, Carton division will face a reduction in profit on account of higher material cost. In addition, Pulp division will make extra contribution on account of extra sale.

Company financials will get improved since $20.3 per ton will not be spent outside by Carton Division and the same material will be made at $14 per ton in-house by Pulp Division. Hence Company will see a increase in profit of $6.3 per ton ($20.3 - $14).

Increase in profit = 32,000 * 6.3 = $201,600
(Fixed Cost will remain same and there is a spare capacity of 32,000 tonnes already available with the Pulp Division).

It should be noted that For Part 4, Internal Transfer Price will not play any role for determining the company profits on whole level.