Serviflow manufactures products that move and measure various fluids, ranging from water to high-viscosity polymers, corrosive or abrasive chemicals, toxic substances, and other difficult pumping media. The Supply Division, a profit center, manufactures all products for the various marketing divisions, which also are profit centers. One of the marketing divisions, the Natural Gas Marketing Division (NGMD), designed and sells a liquid natural gas pressure regulating valve, NGM4010, which the Supply Division manufactures.

To produce one NGM4010, the Supply Division incurs a variable cost of $ 6, and NGMD incurs a variable cost of $ 14. The $ 6 and $ 14 variable costs per unit of NGM4010 are constant and do not vary with the number of units produced or sold. While both the Supply Division and NGMD have substantial fixed costs, for the purpose of this question, assume both divisions’ fixed costs are zero.

The following table depicts how the price of the NGM4010 to outside customers varies with the number of units sold each week. (That is, the external customers’ weekly demand curve for NGM4010 is given by the following formula: P 1000 10 Q, where P is the final selling price and Q is the total number of units sold each week.)

Quantity Purchased Price Paid per Unit by

by the External Customer the External Customer

20..................... $ 800

22 .....................780

24.5..................... 755

26 .....................740

30..................... 700

40..................... 600

45..................... 550

49..................... 510

50..................... 500

60 .....................400

Required:

a. If the senior managers in the corporate headquarters of Serviflow knew all the relevant information ( the variable costs in the Supply Division and NGMD and the market demand curve for NGM4010), what profit maximizing final price would they set for NGM4010 and how many units would they tell the Supply Division to produce and NGMD to sell each week?

b. How much total profit does Serviflow generate each week based on the profit maximizing price- quantity decision made in part (a)?

c. Assume that Serviflow senior managers do not know all the relevant information to choose the profit maximizing price- quantity decision for NGM4010. Instead, they assign the decision rights to set the transfer price to the Supply Division. Assume the Supply Division knows how many units of NGM4010 NGMD will purchase as a function of the transfer price. The following table shows how NGMD’s purchase decision of NGM4010 depends on the transfer price set by the Supply Division.

Transfer Price Units Purchased Weekly by NGMD

$ 480 ..............25.30

490 ..............24.80

491 ..............24.75

492.............. 24.70

493 ..............24.65

494 ..............24.60

495 ..............24.55

496 ..............24.50

497 ..............24.45

498 ..............24.40

499 ..............24.35

500 ..............24.30

( In other words, the Supply Division knows that NGMD’s demand curve for NGM4010 is T 986 20 Q , where T is the transfer price and Q is the number of units of NGM4010 transferred from Supply to NGMD and sold by NGMD each week.) What transfer price will the Supply Division select to maximize the Supply Division’s profit on NGM4010?

d. If the Supply Division selects the transfer price to maximize its profits in part (c), how much profit will the Supply Division make each week, and how much profit will NGMD make each week?

e. Compare the level of firm wide profits calculated in part (b) with the sum of the Supply Division’s and NGMD’s profits calculated in part (d). Which one is larger (firm profits or Supply Division profits plus NGMD profits), and explain why.

f. Suppose corporate headquarters has all the information about customer demand and costs in the two divisions [the same assumption as in part (a)], but instead of telling the two divisions how many units to produce and transfer each week, they set the transfer price on NGM4010. What transfer price would corporate headquarters set in order to maximize firm wide profit?

g. What organizational problems are created if the transfer price for NGM4010 is set following your recommendation in part (f) above? Describe the dysfunctional incentives created by such a transfer pricing rule.