Division Y has asked Division X of the same company to supply it with 5,000 units of part L763 this year to use in one of its products. Division Y has received a bid from an outside supplier for the parts at a price of $33.00 per unit. Division X has the capacity to produce 20,000 units of part L763 per year. Division X expects to sell 18,000 units of part L763 to outside customers this year at a price of $34.00 per unit. To fill the order from Division Y, Division X would have to cut back its sales to outside customers. Division X produces part L763 at a variable cost of $25.00 per unit. The cost of packing and shipping the parts for outside customers is $2.00 per unit. These packing and shipping costs would not have to be incurred on sales of the parts to Division Y.Required:a. What is
the range of transfer prices within which both the Divisions' profits would increase as a result of agreeing to the transfer of 5,000 parts this year from Division Y to Division X?b. Is it in the best interests of the overall company for this transfer to take place? Explain.
What will be an ideal response?
a.
From the perspective of Division Y, profits would increase as a result of the transfer if and only if:
Transfer price > Variable cost + Opportunity cost
The opportunity cost is the contribution margin on the lost sales, divided by the number of units transferred:
Opportunity cost = [($34.00 ? $25.00 ? $2.00) × 3,000*] / 5,000 = $4.20
| *Demand from outside customers | 18,000 | |
| Units required by Division Y | 5,000 | |
| Total requirements | 23,000 | |
| Capacity | 20,000 | |
| Required reduction in sales to outside customers | 3,000 | |
? | ||
| Therefore, Transfer price > $25.00 + $4.20 = $29.20. | ||
| ? | ||
| From the viewpoint of Division X, the transfer price must be less than the cost of buying the units from the outside supplier. Therefore, | ||
| Transfer price < $33.00. | ||
| Combining the two requirements, we get the following range of transfer prices: | ||
| $29.20 < Transfer price < $33.00. | ||
| ? | ||
| b. | ||
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