Weller Industries is a decentralized organization with six divisions. The company’s Electrical Division produces a variety of electrical items, including an X52 electrical fitting. The Electrical Division (which is operating at capacity) sells this fitting to its regular customers for $8.30 each; the fitting has a variable manufacturing cost of $4.70.

Weller Industries is a decentralized organization with six divisions. The company’s Electrical Division produces a variety of electrical items, including an X52 electrical fitting. The Electrical Division (which is operating at capacity) sells this fitting to its regular customers for $8.30 each; the fitting has a variable manufacturing cost of $4.70.

The company’s Brake Division has asked the Electrical Division to supply it with a large quantity of X52 fittings for only $6.30 each. The Brake Division, which is operating at 50% of capacity, will put the fitting into a brake unit that it will produce and sell to a large commercial airline manufacturer. The cost of the brake unit being built by the Brake Division follows:

Purchased parts (from outside vendors)	$	23.60
Electrical fitting X52		6.30
Other variable costs		14.43
Fixed overhead and administration		8.40
Total cost per brake unit	$	52.73

Although the $6.30 price for the X52 fitting represents a substantial discount from the regular $8.30 price, the manager of the Brake Division believes the price concession is necessary if his division is to get the contract for the airplane brake units. He has heard “through the grapevine” that the airplane manufacturer plans to reject his bid if it is more than $54 per brake unit. Thus, if the Brake Division is forced to pay the regular $8.30 price for the X52 fitting, it will either not get the contract or it will suffer a substantial loss at a time when it is already operating at only 50% of capacity. The manager of the Brake Division argues that the price concession is imperative to the well-being of both his division and the company as a whole.

Weller Industries uses return on investment (ROI) to measure divisional performance.

Required:

1. Assume that you are the manager of the Electrical Division.

a. What is the lowest acceptable transfer price for the Electrical Division?

b. Would you supply the X52 fitting to the Brake Division for $6.30 each as requested?

2. Calculate the net positive effect on the company's profit per brake unit the Electrical Division to supply the fittings to the Brake Division and if the airplane brakes can be sold for $54?

3. In principle, within what range would that transfer price lie?

Explanation

1.

a.

The Electrical Division is presently operating at capacity; therefore, any sales of X52 electrical fitting to the Brake Division will require that the Electrical Division give up an equal number of sales to outside customers. Using the transfer pricing formula, we get a minimum transfer price of:

Transfer price ≥	Variable cost per unit	+	Total contribution margin on lost sales
			Number of units transferred

Transfer price ≥   $4.70 + ($8.30 − $4.70)

Transfer price ≥   $4.70 + $3.60

Transfer price ≥   $8.30

b.

Thus, the Electrical Division should not supply the fitting to the Brake Division for $6.30 each. The Electrical Division must give up revenues of $8.30 on each fitting that it sells internally. Because management performance in the Electrical Division is measured by ROI, selling the fittings to the Brake Division for $6.30 would adversely affect these performance measurements.

2.

The key is to realize that the $8.40 in fixed overhead and administrative costs contained in the Brake Division’s $52.73 “cost” per brake unit is not relevant. There is no indication that winning this contract would actually affect any of the fixed costs. If these costs would be incurred regardless of whether or not the Brake Division gets the airplane brake contract, they should be ignored when determining the effects of the contract on the company’s profits. Another key is that the variable cost of the Electrical Division is not relevant either. Whether the fittings are used in the brake units or sold to outsiders, the production costs of the fittings would be the same. The only difference between the two alternatives is the revenue on outside sales that is given up when the fittings are transferred within the company.

Selling price of the brake units			$	54.00
Less:
The cost of the fittings used in the brakes (i.e. the lost revenue from sale of fittings to outsiders)	$	8.30
Variable costs of the Brake Division excluding the fitting ($23.60 + $14.43)		38.03		46.33
Net positive effect on the company’s profit			$	7.67

Therefore, the company as a whole would be better off by $7.67 for each brake unit that is sold to the airplane manufacturer.

 

3.

As shown in part (1) above, the Electrical Division would insist on a transfer price of at least $8.30 for the fitting. Would the Brake Division make any money at this price? Again, the fixed costs are not relevant in this decision because they would not be affected. Once this is realized, it is evident that the Brake Division would be ahead by $7.67 per brake unit if it accepts the $8.30 transfer price.

 

Selling price of the brake units			$	54.00
Less:
Purchased parts (from outside vendors)	$	23.60
Electrical fitting X52 (assumed transfer price)		8.30
Other variable costs		14.43		46.33
Brake Division contribution margin			$	7.67

In fact, because there is a positive contribution margin of $7.67, any transfer price within the range of $8.30 to $15.97 (= $8.30 + $7.67) will improve the profits of both divisions. So yes, the managers should be able to agree on a transfer price.

Answer