Transfer Pricing with and without Capacity Constraints Elise Carpets Inc. has ju
ID: 2594181 • Letter: T
Question
Transfer Pricing with and without Capacity Constraints
Elise Carpets Inc. has just acquired a new backing division that produces a rubber backing, which it sells for $3.30 per square yard. Sales are about 1,200,000 square yards per year. Since the Backing Division has a capacity of 2,000,000 square yards per year, top management is thinking that it might be wise for the company’s Tufting Division to start purchasing from the newly acquired Backing Division. The Tufting Division now purchases 600,000 square yards per year from an outside supplier at a price of $3.00 per square yard. The current price is lower than the competitive $3.30 price as a result of the large quantity discounts. The Backing Division’s cost per square yard follows.
Direct materials.......................................................................$1.80
Direct labor...........................................................................0.45
Variable overhead.....................................................................0.37
Fixed overhead (1,200,000 level) .......................................................0.1 5
Total cost.............................................................................$2.77
Required
a. If both divisions are to be treated as investment centers and their performance evaluated by the ROI formula, what transfer price would you recommend? Why?
b. If fixed costs are assumed not to change, determine the effect on corporate profits of making the backing.
c. Based on your transfer price, would you expect the ROI in the Backing Division to increase, decrease, or remain unchanged? Explain.
d. What would be the effect on the ROI of the Tufting Division using your transfer price? Explain.
e. Assume that the Backing Division is now selling 2,000,000 square yards per year to retail outlets.
What transfer price would you recommend? What will be the effect on corporate profits?
f. If the Backing Division is at capacity and decides to sell to the Tufting Division for $3.00 per
square yard, what will be the effect on the company’s profits?
Explanation / Answer
a. In the given case, backing division has excess capacity of 800,000 sq yards per year which is idle capacity and not used by the Backing division for sale in the market. Therefore, any unit till 800,000 unnits if transferred to other division can be transferred at cost of manufacturing such units. Since the total cost of Manufacturing is $2.77, backing division can easily transfer units at this cost without having to reduce it's contribution from external market. On the other hand, Tufting division is currently purchasing the product at $3 per unit from external market and therefore, will reject price above $3 but will accept lower price of $2.77. Therefore, transfer price is $2.77.
NOTE: Calculation of manufacturing cost
Cost = Materials + Labor + Variable Overheads + extra fixed cost over 1,200,000 units (i.e $0.15) = $2.77
b. Calculation profits
Profits of Backing Division
Sale to external market
Transfer pricing
Particulars
Amount
Particulars
Amount
Sale
3.30
Transfer pricing
2.77
Less: Cost of manufacturing
2.62
Less: Cost of sales
2.62
Contribution
0.68
Contribution
0.15
Less: Fixed cost
015
Less: Fixed cost
0
Profit
0.53
Profit
0.15
Unit sold
1,200,000
Units transferred
600,000
Total Profit
636,000
Total Profit
90,000
Savings in cost of Tufting Division = $3 - $2.77 = $0.23 per unit
Total Savings in cost of tufting division = 600,000 x $0.23 = $138,000
Overall increase in Corporate profits = 90,000 + 138,000 = $228,000
C. Since the overall profts of Backing division has futher increased by $90,000. ROI will also increase of Backing division.
D. Tufting division's cost of goods sold will decrease by $138,000 as shown in second part since there is savings in material cost and therefore overall profts of Tufting division will increase. As a result ROI of the Tufting Division will also increase.
Sale to external market
Transfer pricing
Particulars
Amount
Particulars
Amount
Sale
3.30
Transfer pricing
2.77
Less: Cost of manufacturing
2.62
Less: Cost of sales
2.62
Contribution
0.68
Contribution
0.15
Less: Fixed cost
015
Less: Fixed cost
0
Profit
0.53
Profit
0.15
Unit sold
1,200,000
Units transferred
600,000
Total Profit
636,000
Total Profit
90,000
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