TRANSFER PRICING
Nashmen Manufacturing Company manufactures lawn mowers, snow
blowers, and tillers. The company has six divisions, each of which is
considered an investment center. Division managers are evaluated and
rewarded on the basis of ROI and RI. It has been stated company policy that
internal transfers should be made whenever possible and that the transfer
price should be full cost plus 10%. Ken Booth, vice president of the company,
is reviewing the company’s current internal transfer pricing policy based on a
memo provided by Dana Lemmons, director of the Parts Division. The memo
is shown below.
To: Ken Booth - Vice President
To: Dana Lemmons - Parts Director
Subject: Transfer Pricing Policy
Ken, I have serious concerns about our current transfer pricing policy (full
cost plus 10%). First, I believe this policy is a false reflection of my division's
ROI - significantly lower than it actually is. Second, it discourages my division
from cutting manufacturing costs.
For example, consider the production of Part 34 (small carburetors). We
currently have a production capacity of 300,000 units per year. Of these
300,000 units, 200,000 are transferred to the Small Motor division at a price
of $16.50 per unit. 100,000 units are sold to outside customers at a price of
$20 per unit. I know that we could sell all of the carburetors outside. By
forcing us to transfer internally, we are losing revenue and demonstrating a
smaller ROI than we otherwise would have.
But the problem is much more serious. Our engineers have created a new
design that would allow us to reduce our fixed manufacturing overhead costs
for carburetors by $5/unit. However, if we implement this design, our
transfer price would drop to $11, and the revenue we would get from internal
sales would be significantly reduced. All of those savings and more have
been passed on to the purchasing department.
In my opinion, all of these problems could be solved by allowing each
division manager to set his own transfer price and allowing each of us to sell
or buy products as we saw fit.
After reading the memo, Ken also gathered the following information:
Carburetor Manufacturing Cost
Direct Materials $6.00
Direct Labor 1.25
Variable Manufacturing Overhead 1.50
Fixed Manufacturing Overhead 6.25
Total Cost $15.00
Small Motor Manufacturing Cost
Carburetor $16.50
Direct Materials 23.50
Direct Labor 8.75
Variable Manufacturing Overhead 3.25
Fixed Manufacturing Overhead 8.40
Total Cost $60.40
Small Motor Production & Consumption Volume
Production 200,000
Consumption 200,000
Unit Selling Price $75
Requirements:
1. Suppose the Parts division makes the new design changes. Assume that
internal demand for the carburetor does not change.
a. How will the company's profits change as a result of implementing
this decision?
b. How will the profits of the Parts division and the Small Motors
division change as a result of implementing this decision.
c. Are Dana's concerns valid?
d. Are all the benefits of the design improvement passed on to the
Small Motors division?
2. Using requirement 1. Suppose that the cost of the Small Motor increase
internal demand from 200,000 to 300,000 units. Evaluate the impact on the
company's profits as well as on the profits of each division. If Dana had
anticipated these effects, do you think she would have implemented the
cost-cutting design?
3. Using the original information. Ken Booth wants to know the impact of
decentralizing internal pricing decisions. Assuming that the Small Motors
division can purchase an equivalent quality carburetor for $20 from an
outside supplier, provide Dana with a comprehensive assessment of these
impacts. Your assessment should include information about the impact on
the company's profits as a whole as well as on the profits of each division.
Make recommendations about the incentives Dana might have for
implementing a cost-cutting design.