Finnish Corporation has a Supply Division that does work for other divisions in the company as well as for outside customers. The company's Custodial Products Division has asked the Supply Division to provide it with 10,000 special parts each year. The special parts would require $15.00 per unit in variable production costs.The Custodial Products Division has a bid from an outside supplier for the special parts at $29.00 per unit. In order to have time and space to produce the special parts, the Supply Division would have to cut back production of another product - the H56 that it is currently producing. The H56 sells for $32.00 per unit and requires $19.00 per unit in variable production costs. Packaging and shipping costs of the H56 are $3.00 per unit. Packaging and shipping costs for

Question

the new special part would be only $1.00 per unit. The Supply Division is currently producing and selling 40,000 units of the H56 each year. Production and sales of the H56 would drop by 20% if the new special part is produced for the Custodial Products Division.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 10,000 special parts per year from the Supply Division to the Custodial Products Division?(b) Is it in the best interests of Finnish Corporation for this transfer to take place? Explain.

What will be an ideal response?

Answer 1

(a)
In order for the profit of the Supply Division to increase as a result of the transfer, the transfer price must be greater than $24.00 per unit:

Transfer price > [Outlay cost ($15 + $1) + Opportunity cost ($8)] = $24.00.The opportunity cost of the special part is the contribution margin on the lost sales divided by the number of units transferred = [($32.00 ? $19.00 ? $3.00) × (40,000 × 20%]/10,000 = $8.00.

In order for the profit of the Custodial Products Division to increase as a result of the transfer, the transfer price must be less than the cost of buying the units from the outside supplier. Therefore, the transfer price must be less than $29.00.

Combining the two requirements, the range of transfer prices is between $24.00 and $29.00.

(b)
Yes, the transfer should take place. From the perspective of the entire company, the cost of transferring the units within the company is $24.00, but the cost of purchasing the special parts from the outside supplier is $29.00. Therefore, the company's profits increase on average by $5.00 for each of the special parts that is transferred within the company, even though this would cut into production and sales of another product.