Macalester, Inc., manufactures heating and air conditioning units in its six divisions. One division, the Components Division, produces electronic components that can be used by the other five. All the components produced by this division can be sold to outside customers; however, from the beginning, about 70 percent of its output has been used internally. The current policy requires that all internal transfers of components be transferred at full cost. Recently, Loren Ferguson, the new chief executive officer of Macalester, decided to investigate the transfer pricing policy. He was concerned that the current method of pricing internal transfers might force decisions by divisional managers that would be suboptimal for the firm. As part of his inquiry, he gathered some information concerning Part 4CM, used by the Small AC Division in its production of a window air conditioner, Model 7AC. The Small AC Division sells 100,000 units of Model 7AC each year at a unit price of $55. Given current market conditions, this is the maximum price that the division can charge for Model 7AC. The cost of manufacturing the air conditioner is computed as follows:
Part 4CM …………………… $ 7
Direct materials …………….. 20
Direct labor ………………… 16
Variable overhead ………….. 3
Fixed overhead ……………… 6
Total unit cost ………………. $52
The window unit is produced efficiently, and no further reduction in manufacturing costs is possible. The manager of the Components Division indicated that she could sell 10,000 units (the division’s capacity for this part) of Part 4CM to outside buyers at $12 per unit. The Small AC Division could also buy the part for $12 from external suppliers. She supplied the following detail on the manufacturing cost of the component:
Direct materials …………………… $3.00
Direct labor ……………………….. 0.50
Variable overhead ………………… 1.50
Fixed overhead …………………… 2.00
Total unit cost …………………… $7.00

Required:
1. Compute the firmwide contribution margin associated with Part 4CM and Model 7AC. Also, compute the contribution margin earned by each division.
2. Suppose that Loren Ferguson abolishes the current transfer pricing policy and gives divisions autonomy in setting transfer prices. Can you predict what transfer price the manager of the Components Division will set? What should be the minimum transfer price for this part? The maximum transfer price?
3. Given the new transfer pricing policy, predict how this will affect the production decision for Model 7AC of the manager of the Small AC Division. How many units of Part 4CM will the manager of the Small AC Division purchase, either internally or externally?
4. Given the new transfer price set by the Components Division and your answer to Requirement 3, how many units of 4CM will be sold externally?
5. Given your answers to Requirements 3 and 4, compute the firmwide contribution margin. What has happened? Was Loren’s decision to grant additional decentralization good or bad?

SOLUTION

1. Part 4CM Model 7AC Company Sales $ 70,000* $ 550,000 $ 620,000 Variable expenses 50,000 460,000 510,000 Contribution margin $ 20,000 $ 90,000 $110,000

*While all 10,000 units could be sold externally, currently none are.

2. The transfer price should be the market price of $12. This is the minimum price for the Components Division and the maximum price for the Small AC Division.

3. Unless the manager of the Small AC Division is able to increase the price of Model 7AC, he will discontinue production and will not purchase any of the component. (The cost of producing the window unit will increase from $52 to $57, a cost greater than the current selling price.)

4. All 10,000 units of Part 4CM will be sold externally at the market price of $12 per unit.
5. Sales $ 120,000 Variable expenses 50,000 Contribution margin $ 70,000

The contribution to profits increases by $20,000. The CEO made the correct decision.