Question

Johnny C. has two divisions. East division sells a component (L689) to West division. West then assembles a product, CAGE, using L689 and sells it to customers. East division incurs $50 of variable cost per unit of L689 and allocates $80 of fixed cost to each unit. East’s factory has limited space, so every unit of L689 it produces means one less unit of L690 is made. While L689 is only sold to West division, East division sells L690 to outside customers for $150 per unit while incurring $40 in variable cost per unit. In addition to the cost of L689, West division incurs $90 in variable cost and $100 in allocated fixed cost to make each unit of CAGE, which sells for $502. If necessary, West could contract with an outside supplier for a slightly different part, M777, that costs $200 per unit and would require an additional $25 in cost to convert it into an equivalent of L689. It will be in the best interest of Johnny C for the transfer to occur.

a) What is the lowest transfer price that will ensure that both divisions will voluntarily participate in the transfer (ie, if the price was lower than this level, one of the divisions would refuse to participate)?

b) What is the highest price that ensures both divisions will voluntarily participate in the transfer (ie, if the price was higher than this level, one of the divisions would refuse to participate)?

c) The manager of Johnny C decides to impose a transfer price since the two divisions cannot agree. He chooses the highest feasible price. His reasoning is that selling for a high price is better for Johnny C's profit. Is the manager's reasoning sound? Explain why or why not. (Limit of 25 words.)

Answer 1

Answer A

	East division	West division
	L689	L690	Cage using L689 at VC of East	Cage using L689 at Minimum agreeable price to East	Cage using M777
Sale	160	150	502	502	502
Material	0	0	50	160	200
VC	50	40	90	90	115
Contribution	110	110	362	252	187

$ 160 is calculated in reverse logic where to keep up with L690 profitability i.e. $110 per unit, L689 will have to be sold at $160 to West. Fixed costs would not be relevant for the decision making as they will continue to be incurred. The answer is $160.

Answer B

	East division	West division
	L689	L690	Cage using L689	Cage using L689 lowest agreeable to East	Cage using L689 lowest agreeable to West	Cage using M777
Sale	160	150	502	502	502	502
Material	0	0	50	160	225	200
VC	50	40	90	90	90	115
Contribution	110	110	362	252	187	187

The answer is $225. As you can see from the table above, contribution of West division by manufacturing cage with M777 is $187.  It becomes a bare minimum for them. $225 is calculated as 502-90-187.

Answer C

The manager's reasoning has a flaw and it is not sound. Internal price between the departments would not affect Johny C's profit. It would only affect profitabilities of East and West divisions. CAGE would have a contribution of $362 ($502- VC at East $50 - VC of west $90) and it would be the same no matter what the transfer price between department is.