Fyodor Corporation has a Parts Division that does work for other Divisions in the company as well as for outside customers. The company's Machine Division has asked the Parts Division to provide it with 8,000 special parts each year. The special parts would require $19.00 per unit in variable production costs.The Machine Division has a bid from an outside supplier for the special parts at $27.00 per unit. In order to have time and space to produce the special part, the Parts Division would have to cut back production of another part-the QR4 that it presently is producing. The QR4 sells for $34.00 per unit, and requires $18.00 per unit in variable production costs. Packaging and shipping costs of the QR4 are $2.00 per unit. Packaging and shipping costs for the new special part would be

Question

only $0.50 per unit. The Parts Division is now producing and selling 40,000 units of the QR4 each year. Production and sales of the QR4 would drop by 5% if the new special part is produced for the Machine 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 8,000 special parts per year from the Parts Division to the Machine Division?b. Is it in the best interests of Fyodor Corporation for this transfer to take place? Explain.

What will be an ideal response?

Answer 1

a. 
From the perspective of the Parts Division, 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 ? $18.00 ? $2.00) × 2,000*] / 8,000 = $3.50

* 5% × 40,000 = 2,000

Therefore, Transfer price > ($19.00 + $0.50) + $3.50 = $23.00.


From the viewpoint of the Machine Division, the transfer price must be less than the cost of buying the units from the outside supplier. Therefore, Transfer price < $27.00.

Combining the two requirements, we get the following range of transfer prices: $23.00 < Transfer price < $27.00.


b.

Yes, the transfer should take place. From the viewpoint of the entire company, the cost of transferring the units within the company is $23.00, but the cost of purchasing the special parts from the outside supplier is $27.00. Therefore, the company's profits increase on average by $4.00 for each of the special parts that is transferred within the company, even though this would cut into production and sales of another product.