Question

Hamlet Industries is organized into two divisions, Fabrication and Finishing. Both divisions are considered to be profit centers, and the two division managers are evaluated in large part on divisional income. The company makes a single product. It is manufactured in Fabrication and then packaged and sold in Distribution. There is no intermediate market for the product. The monthly income statements, in thousands of dollars, for the two divisions follow. Production and sales amounted to 35,800 units.

Fabrication ($000) Distribution ($000)
Revenues $ 5,370 $ 8,950
Variable costs 4,296 6,623
Contribution margin $ 1,074 $ 2,327
Fixed costs 800 1,527
Divisional profit $ 274 $ 800
Assume there is no special order pending.

Required:
a. What transfer price would you recommend for Hamlet Industries?
b. Using your recommended transfer price, what will be the income of the two divisions, assuming monthly production and sales of 35,800 units?
c. The manager of the Fabrication Division complains about the transfer price, saying that division profits are unfairly low. The two division managers meet and negotiate a transfer price of $148. What will be the income of the two divisions, assuming monthly production and sales of 35,800 units.

Answer 1

a. The recommended transfer price for Hamlet Industries is the variable cost of the Fabrication Division. b. With the recommended transfer price, Fabrication's profit is $274, and Distribution's profit is $3,127. c. With the negotiated transfer price of $148, Fabrication's profit remains $274, but Distribution's profit increases to $4,767.

a. Recommended Transfer Price:

- The transfer price should ideally be based on the variable cost of the Fabrication Division, as this allows the Finishing Division to cover its variable costs and contribute to overall profit.

b. Income with Recommended Transfer Price:

- Fabrication Division:

- Revenues: $5,370 (same as before)

- Variable Costs: $4,296 (same as before)

- Contribution Margin: $1,074 (same as before)

- Fixed Costs: $800 (same as before)

- Divisional Profit: $274 (same as before)

- Distribution Division:

- Revenues: $8,950 (same as before)

- Variable Costs: $4,296 (transfer price based on Fabrication variable cost)

- Contribution Margin: $4,654 ($8,950 - $4,296)

- Fixed Costs: $1,527 (same as before)

- Divisional Profit: $3,127 ($4,654 - $1,527)

c. Income with Negotiated Transfer Price ($148):

- Fabrication Division:

- Revenues: $5,370 (same as before)

- Variable Costs: $4,296 (same as before)

- Contribution Margin: $1,074 (same as before)

- Fixed Costs: $800 (same as before)

- Divisional Profit: $274 (same as before)

- Distribution Division:

- Revenues: $8,950 (same as before)

- Variable Costs: $2,656 ($148 * 35,800)

- Contribution Margin: $6,294 ($8,950 - $2,656)

- Fixed Costs: $1,527 (same as before)

- Divisional Profit: $4,767 ($6,294 - $1,527)

Negotiating a transfer price of $148 significantly impacts the Distribution Division's profit, increasing it by $1,640 compared to the recommended transfer price.