Question

Petro Refinery, Inc., located in Houston, TX, has separate divisions for “Unleaded Gasoline” and “Jet Fuel”.

The variable costs are as follows:

■ Unleaded Gasoline division: $1.75 per gallon of unleaded gasoline

■ Jet Fuel division: $1.95 per gallon jet fuel

Assume that there is no loss in processing unleaded gasoline into jet fuel. Unleaded Gasoline can be sold at $2.25 per gallon. Jet Fuel can be sold at $3.95 per gallon.

Required:

1. Should Petro Refinery process the unleaded gasoline into its jet fuel? Show your calculations. Explain.

2. Assume that Petro Refinery headquarters requires that the internal transfers are made at 130% of variable cost. What would be your reaction to this policy as the division manager for Unleaded Gasoline? Is this action in the best interest of Petro Refinery as a whole? Explain.

3. Assume that internal transfers are made at market prices. Will each division maximize its division operating-income contribution by adopting the action that is in the best interest of Petro Refinery as a whole? Explain.

Answer 1

Answer 1 :

No,

Petro Refinery should not process the unleaded gasoline into its jet fuel

Given that:

Assume that there is no loss in processing unleaded gasoline into jet fuel. Unleaded Gasoline can be sold at $2.25 per gallon. Jet Fuel can be sold at $3.95 per gallon.

Variable cost of  Jet Fuel division = $1.95 per gallon jet fuel

Financial advantage of processing the unleaded gasoline into its jet fuel = 3.95 - 1.95 - 2.25 = ($0.25)

Since there is financial disadvantage, Petro Refinery should not process the unleaded gasoline into its jet fuel.

Answer 2 (a):

Assuming that Petro Refinery headquarters requires that the internal transfers are made at 130% of variable cost.

The transfer price of unleaded gasoline = 130% * 1.75 = $2.275 Per gallon.

The transfer price will be higher than the market price ($2.25) per gallon of unleaded gasoline.

As a division manager for Unleaded Gasoline I shall be happy with it.

Answer 2 (b):

This action is not in the best interest of Petro Refinery as a whole. There is no reason why Jet Fuel division should buy from internal division when they can purchase externally at a lower price. This will be detrimental to Jet Fuel division and company as a whole.

If Jet fuel division has to buy internally at a higher price, their division's profit will take a hit. To maintain profit if they increase prices, they will loose customers. As a whole for the company this policy will have a negative impact.

Answer 3:

We have observed in answer 1 above that, there is financial disadvantage to process jet fuel and Petro Refinery should not process the unleaded gasoline into its jet fuel.

For company as a whole:

If we look at total variable cost per gallon for jet fuel = 1.75 + 1.95 = $3.70

Contribution per gallon of jet fuel = 3.95 - 3.70 = $0.25

Contribution margin per gallon of unleaded gasoline = 2.25 - 1.75 = $0.50

If internal transfers are made at market prices, unleaded gasoline division will maximize its profit. But jet fuel division will incur losses. Hence it is not in company's best interest.

If there is enough demand the company should produce and sell Unleaded gasoline only. However, there is idle capacity in unleaded gasoline division, then they should produce and transfer unleaded gasoline to jet fuel division at variable cost.