Transfer Pricing Milk Products is a dairy farm located in the Midwest. The dairy

Question

Transfer Pricing

Milk Products is a dairy farm located in the Midwest. The dairy farm has two divisions, milk and cheese. Both divisions generate revenues and costs and, as such, are treated as profit centers. Jordyn is in charge of the milk division, which has fixed costs of $50,000 a month and variable costs of $1.50 per gallon of milk. The milk division produces 200,000 gallons of milk each month. Austin manages the cheese division and uses 1 gallon of milk from Jordyn’s cows to make a block of cheese. The process of converting milk to cheese requires variable costs of $5 per block in addition to $20,000 fixed costs. The amount of cheese Austin sells is based on how much he charges for each block, as follows: Block price Blocks sold $10 $5,000 $11 $4,500 $12 $4,000 $13 $3,500 $14 $3,000 $15 $2,500 Jordyn can sell milk externally for $2.25 per gallon. Jordyn and Austin have been fighting over the price of milk. Jordyn thinks Austin should pay her $2.25 per gallon and Austin thinks he should pay $1.50 per gallon. Please do the following:

a) How many blocks of milk Austin will choose to produce and sell if transfer price is $1.50.

b) How many blocks of milk Austin will choose to produce and sell if transfer price is $2.25.

c). Which price is better for the firm and why? Also, what should happen if Jordyn can sell all her milk externally for $2.25?

(please show workout)

Explanation / Answer

a)

Variable cost of production per block of milk = cost of 1 gallon of milk + conversion cost = $1.50 + $5 = $6.50

Austin should choose to produce and sale 3500 blocks of milk as it will give the highest profit of $2750

b)

Variable cost of production per block of milk = cost of 1 gallon of milk + conversion cost = $2.25 + $5 = $7.25

Austin should choose to produce and sale 3000 blocks of milk as it will give the highest profit of $250

c)

The transfer price $1.50 per gallon of milk is better for the firm as it will help Austin to generate a net operating profit of $2750 which is more than $250, if the transfer price were $2.25/gallon of milk.

If Jordyn can sell all her milk to external market @ $2.25/gallon, the net operating profit will be $100000 for Jordyn. In that case, Austin will purchase milk from outside market @ $2.25 and can earn a profit of $250 (at 3000 blocks of milk).

Block of cheese sold 5000 4500 4000 3500 3000 2500 Price per block($) 10 11 12 13 14 15 Sales Revenue($) 50000 49500 48000 45500 42000 37500 Variable cost ($) 32500 29250 26000 22750 19500 16250 Conribution ($) 17500 20250 22000 22750 22500 21250 Fixed cost ($) 20000 20000 20000 20000 20000 20000 Operating profit ($) -2500 250 2000 2750 2500 1250

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