Question

Weller Industries is a decentralized organization with six divisions. The company’s Electrical Division produces a variety of electrical items, including an X52 electrical fitting. The Electrical Division (which is operating at capacity) sells this fitting to its regular customers for $9.60 each; the fitting has a variable manufacturing cost of $5.11.

The company’s Brake Division has asked the Electrical Division to supply it with a large quantity of X52 fittings for only $7.60 each. The Brake Division, which is operating at 50% of capacity, will put the fitting into a brake unit that it will produce and sell to a large commercial airline manufacturer. The cost of the brake unit being built by the Brake Division follows:

Purchased parts (from outside vendors) $ 24.60
Electrical fitting X52 7.60
Other variable costs 14.87
Fixed overhead and administration 8.90
Total cost per brake unit $ 55.97

Although the $7.60 price for the X52 fitting represents a substantial discount from the regular $9.60 price, the manager of the Brake Division believes the price concession is necessary if his division is to get the contract for the airplane brake units. He has heard "through the grapevine" that the airplane manufacturer plans to reject his bid if it is more than $57 per brake unit. Thus, if the Brake Division is forced to pay the regular $9.60 price for the X52 fitting, it will either not get the contract or it will suffer a substantial loss at a time when it is already operating at only 50% of capacity. The manager of the Brake Division argues that the price concession is imperative to the well-being of both his division and the company as a whole.

Weller Industries uses return on investment (ROI) to measure divisional performance.

Required:

1. Assume that you are the manager of the Electrical Division.
a. What is the lowest acceptable transfer price for the Electrical Division?
b. Would you supply the X52 fitting to the Brake Division for $7.60 each as requested?
2. Assuming the airplane brakes can be sold for $57, what is the financial advantage (disadvantage) for the company as a whole (on a per unit basis) if the Electrical Division supplies fittings to the Brake Division?
3. In principle, within what range would the transfer price lie?

Answer 1

The lowest acceptable transfer price for the Electrical Division is the variable cost of $5.11, but considering the division's operating capacity and the regular price of $9.60, a transfer at $7.60 could be questionable. The financial advantage for the company per brake unit would be a profit of $1.03. The transfer price range is between the variable cost and the full cost plus opportunity cost.

Step-by-step explanation:

Understanding Transfer Pricing and Divisional ROI

The lowest acceptable transfer price for the Electrical Division, operating at capacity, should be the variable cost of producing the X52 electrical fitting, which is $5.11. Anything above this will contribute to covering fixed costs and profit. However, the regular selling price is $9.60, which includes a contribution to fixed costs and profit.

As the manager of the Electrical Division, I would consider supplying the X52 fitting to the Brake Division for $7.60 if the incremental costs of producing more fittings were covered and provided it would not cannibalize sales at the regular price. Any price above the variable cost contributes to covering fixed costs and could be acceptable if it does not affect regular business. However, since the division is operating at capacity, this would involve forgoing sales at $9.60.

For the financial advantage computation, if the Brake Division can sell the brake units for $57, the total cost per brake unit is $55.97 with the discounted fitting price. Therefore, the company makes a profit of $1.03 per brake unit through internal transfer. However, this ignores the opportunity cost of not selling the fittings to regular customers at a higher price.

The transfer price range should be between the variable cost of production ($5.11) and the full cost plus an opportunity cost margin. Essential for calculating this range is an understanding of the company's overall strategic goals and the impact on divisional ROI.