Jose Martinez is the CEO of ShakeIt, a producer of premium ice cream. ShakeIt has two divisions, the supplying division and the processing division. The supplying division supplies milk, the main ingredient, to the processing division. Jose is an ambitious entrepreneur, and he is hoping to soon sell ShakeIt, which is a private company, to one of the larger competitors. The supplying division buys milk from local farmers for $5 per 10 gallons, and incurs $1 of variable costs per 10 gallons transported to the processing division (the supplying division doesn’t incur any material fixed costs). The processing division could buy milk of the same high quality for $8 per 10 gallons on the outside market. Jose is trying to “whip his company into shape” by implementing a transfer pricing system that he views as providing very strong incentives for the two divisions to work hard: The supplying division will get reimbursed for its incremental costs of supplying the milk to the processing division; the processing division is charged the price that it would have to pay on the open market.

Required

1. What is the profit for the supplying division of supplying 10 gallons of milk to the processing division under Jose’s transfer pricing system? Do you think that the transfer pricing system incentivizes the managers of the supplying division to work hard, as Jose intends?
2. In the back of Jose’s mind is that one of the larger competitors may be interested in buying only one of the divisions, and not his entire company. He is patting himself on the back for choosing the transfer pricing system since, in his view, it makes the profitability of each of the two divisions look very good. Do you agree with Jose?