Problem: Transfer Pricing
Lansing Electronics, Inc., manufactures a variety of printers, scanners, and fax machines in its two divisions: the PSF Division, which is the buying division, and the Components Division, which is the supplying division. The Components Division produces electronic components that can be used by the PSF Division. All the components this division produces can be sold to outside customers; however, from the beginning, nearly 90 percent of its output has been used internally. The current policy requires that all internal transfers of components be transferred at full cost
Recently, Cam DeVonn, the chief executive officer of Lansing Electronics, 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 Y34, used by the Buying Division in its production of a basic scanner, Model SC67.
The PSF Division sells 40,000 units of Model SC67 each year at a unit price of $42. Given current market conditions, this is the maximum price that the division can charge for Model SC67. The cost of manufacturing the scanner follows:
Part Y34 $6.50
Direct materials 12.50
Direct labor 3.00
Variable overhead 1.00
Fixed overhead 15.00
Total unit cost $38.0
The scanner is produced efficiently, and no further reduction in manufacturing costs is possible.
The manager of the Components Division indicated that she could sell 40,000 units (the division's capacity for this part) of part Y34 to outside buyers at $12 per unit. The PSF Division could also buy the part for $12 from external suppliers. She supplied the following details on the manufacturing cost of the component:
Direct materials $2.50
Direct labor 0.50
Variable overhead 1.00
Fixed overhead 2.50
Total unit cost $6.50
Task
I. Compute the following contribution margins associated with Part Y34 and Model SC67.
i. Component Division selling Part Y34 internally s)
ii. PSF Division selling Model SC67 externally
iii. Lansing Electronics Inc. as a whole.
II. Suppose that Can DeVonn abolishes the current pricing policy and gives divisions autonomy in setting transfer prices.
i. Can you predict what transfer price the manager of the Components Division will set?
ii. What should the minimum and maximum transfer price for this part be?
III.
i. Given the new transfer pricing policy (your answer in II), predict how this will affect the production decision for Model SC67.
ii. How many units of Part Y34 will the manager of the PSF Division purchase, either internally or externally?
IV. Given the new transfer price set by the Components Division and your answer to Requirement 3, how many units of Part Y34 will be sold externally?
V. Given your answers to Requirements III and IV,
i. Compute the firm wide contribution margin. What has happened?
ii. Was Cam's decision to grant additional decentralization good or bad? Why?