Clear’s Custom Window division has been purchasing a certain window components f

Question

Clear’s Custom Window division has been purchasing a certain window components from Duwee, Cheatim & Hoe Company. However it was determined that it can use one of the frames from the Framing division. The Framing Division, which is operating at capacity, incurs an incremental manufacturing cost of $65 per frame. The picture Framing division can sell all its output to the outside market at a price of $100 per frame, after incurring a variable marketing and distribution cost of $8 per frame. If the Window division purchases frames from Duwee at a price of $100 per frame, it will incur a variable purchasing cost of $7 per frame. Clear View’s division managers can act autonomously to maximize their own division’s operating income.

What is the minimum transfer price at which the Frame manager would be willing to sell frames to the Window division?

What is the maximum transfer price at which the Window manager would be willing to purchase frames from the Framing Division?

Now suppose that the Framing Division can sell only 70% of its output capacity of 20,000 frames per month on the open market. Capacity cannot be reduced in the short run. The Windows Division can assemble and sell more than 20,000 windows per month.

What is the minimum transfer price at which the Framing manager would be willing to sell frames to the Windows Division?

From what point of view of Clear View’s management, how much of the Framing Divisions output should be transferred to the Window Division?

If Clear View mandates the Framing and Windows managers to “split the difference” on the minimum and maximum transfer prices they would be willing to negotiate over, what would be the resulting transfer price? Does this price achieve the outcome desired in requirement 3b?

Explanation / Answer

1. If the Framing Division operates in full capacity and transfer Window components to windows division, it will loose outside slaes, hence the opportunity cost will be taken into account. The opporutnity cost is as follows:

    Opportunity Cost = Sales price - Variable cost = $100 - 65 - 8 = $27

    Minimum transfer price = Variable cost + Opportunity cost

                $92                    =      $65          +   $27

   Note: Since, internal transfer does not require variable marketing and distribution expenses, hece its variable cost is taken at $65 only.

Hence, Framing division minimum transfer price is $92

2. Maximum transfer price at which Window's manager woule be willing to purchase from Framing Division:

    Now, window's division purchasing frames from Duwee Cheatim & Hoe company @ 100 + Variable purchase cost $7, so total purcahse cost is $107. Now Windows division purchase from Framing Division it can reduce variable purcahse cost $7, so it can pay maximum $100 towards purchase price

3. Framing Division can sell only 70% of its production capacity to outside customers, 30% production it can transfer to Window's division without any sacrificing or opportunity cost, then minimum transfer price is only its incremental manufacturing cost only that is $65 which is as follows:

Minimum Transfer price = Variable cost + Opportunity Cost

      $65                           =      $65            +        0

4. How much output of Framing Division would be transferred after selling 70% of its output to outside customers?

    Out of 20,000 frames, Framing Division can transfer only 6,000 frames to Windows Division after selling 70% of its 20,000 frames to outside customers.

5. If Framing Division has excess capacity of 6,000 frames, it can transfer these frames to Window's division with out any opportunitycost. In this situation, Framing division can transfer the frames @ $65 which is the incremental manufacturing cost but it can avoid marketing and distribution cost of $8.

Windows Division can pay maximum $100 that is the price paid to outside supplier viz. Duwee Cheatim & Hoe company, so it can avoid $7 spending on variable purchasing cost.

So, Windows division can pay maximum $100 per frame as it is already paying to outside supplier and minimum transfer price required by Framing division is $65, hence price is negotiable between Window's manager and Framing division manager as long as Windows division purchase price is more than Framing division minimum price, lhen it is profitable to Clear Custom if the negotiable price is between $100 and $65, then contribuiton margin of both Windows division and Framing division can be increased.

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