Case 11A-7 Transfer Pricing; Divisional Performance [LO11-5] Weller Industries i

Question

Case 11A-7 Transfer Pricing; Divisional Performance [LO11-5]

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 $13.60 each; the fitting has a variable manufacturing cost of $9.05.

The company’s Brake Division has asked the Electrical Division to supply it with a large quantity of X52 fittings for only $9.00 each. The Brake Division, which is operating at 60% 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:

Although the $9.00 price for the X52 fitting represents a substantial discount from the regular $13.60 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 $83.15 per brake unit. Thus, if the Brake Division is forced to pay the regular $13.60 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 60% 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 $9.00 each as requested?

2. Calculate the net positive effect on the company's profit per brake unit the Electrical Division to supply the fittings to the Brake Division and if the airplane brakes can be sold for $83.15?

3. In principle, within what range would that transfer price lie?

(For all requirements, enter your "Financial Disadvantage" amounts as a negative value and round your final answers to 2 decimal places.)

Purchased parts (from outside vendors) $ 40.00 Electrical fitting X52 9.00 Other variable costs 20.90 Fixed overhead and administration 13.00 Total cost per brake unit $ 82.90

Explanation / Answer

Answer for question no.1.a:

The minimum acceptable price would the variable manufacturing cost.Hence, minimim acceptable price would be $9.05.

Answer for question no.1.b:

At the price of $9.00 it is not possible to supply, as it is lower than the variable manufacturing cost. Supplying at that price would result directly into loss.

Answer for question no.2:

Price of the airplane brake =$83.15.------(1)

Cost of the airplane brake=$82.90---------(2)

Net operating profit on the air plane brake=(1)-(2)

=$0.25.

If the part is sold at $9.05 then the operating profit would get reduced to $0.25 -$0.05

=$0.20.

Therefore, the net positive effect on the company's profit is $0.20.

Answer for question no.3:

The minimum price range the transfer price should lie is $9.05 to $9.25.

If the transfer price is $9.25 then the cost of manufacturing the brake is $40+$9.25+$20.90+$13

=$83.15 which is the probable selling priceof the brake to the airplane brake unit.

So, the maximum price of the part would be $9.25 and the minimum price would be $9.05.

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