Question

Cascade Containers is organized into two divisions—Manufacturing and Distribution. Manufacturing produces a product that can be sold immediately or transferred to Distribution for further processing and then sold. Distribution only buys from Manufacturing for quality control reasons.

Manufacturing currently sells 2,700 units annually at a price of $600 per unit to outside customers. It sells an additional 1,200 units to Distribution. The unit variable cost in Manufacturing is $300 and annual fixed costs are $400,000. Manufacturing is located in a country with a 20 percent tax rate.

Distribution can sell units that have had further processing for $1,250 each. In addition to what it pays Manufacturing, the variable costs in Distribution are $150 per unit. Annual fixed costs in Distribution are $370,000. Distribution is located in a country with a 10 percent tax rate.

Required:

Suppose Manufacturing would have excess capacity even with the demand from Distribution. Ignoring tax implications, what transfer price would you recommend Cascade Containers adopt?

Answer 1

The recommended transfer price for Cascade Containers' internal transactions between Manufacturing and Distribution, ignoring tax implications and considering excess capacity, should be at least the variable cost of $300 per unit, which covers the cost of producing additional units.

Step-by-step explanation:

The question relates to setting an appropriate transfer price for Cascade Containers where its Manufacturing division produces goods for the Distribution division. Since Manufacturing has excess capacity, the transfer price should cover the variable cost of manufacturing and potentially some contribution to fixed costs, without considering the tax implications. The marginal cost to produce each additional unit is the variable cost, which is $300. As there is excess capacity, the opportunity cost of selling internally as opposed to selling externally is zero. Consequently, Manufacturing would not be sacrificing external sales by fulfilling the internal demand.

Therefore, the recommended transfer price, in this case, would be at least the variable cost of $300 per unit. This approach ensures that the Manufacturing division covers its costs of producing the additional units and may contribute to covering fixed costs, without taking into account the tax difference between the two countries.