Problem:
Transfer Pricing
Cameo Products has two divisions: Office Products and Furniture. Divisional manager are encouraged to maximize ROI at their respective divisions. Mangers are free to decide whether goods will be transferred internally and to determine the prices at which transfer will occur.
The Furniture Division would like to purchase a particular chair manufactured in the Office Products Division and sell it with a computer desk the division recently has designed. The furniture Division can purchase a similar char from an outside supplier for $45. The Office Product Division currently is producing this chair at full capacity and sells it to outside customers at $45. The manager of the Furniture Company is hoping to receive a price concession if the chair is bought internally. The fully absorbed cost to produce the chair is $40 ($32 represents variable costs). If the chair is sold internally, $3 of the variable selling expenses can be avoided.
The managers of the two divisions met to discuss the possible transaction. After some discussions and negotiation, it was decided that the Furniture Division would purchase the chair at the current outside selling price for the next six months. At the end of six months, negotiations can be reopened by either party if desired.
Required to do:
Q1. Based on current information, what is the highest price that the Furniture Division should be willing to pay for the chair? What is the lowest price that the Office Products Division should be willing to accept?
Q2. Assume that the outside sales price of the chair increases to $47. How would this effect the internal transfer price of the chair?
Q3. Assume that because of soft market conditions; demand for the chair has decreased significantly, creating excess idle capacity with the Office Products Division. How would this change affect the internal transfer price of the chair?
Q4. Why is it in the best interest of the company as a whole to allow the decision managers to negotiate internal transfer prices instead of using a fixed, nonnegotiable formula for establishing transfer prices?