P7–10 Transfer price; well-defined intermediate market Time allowed: 45 minutes Hrubec Products plc operates a Pulp Division that manufactures wood pulp for use in the production of various paper goods. Revenue and costs associated with a ton of pulp follow:

Hrubec Products has just acquired a small company that manufactures paper cartons. This company will be treated as a division of Hrubec with full profit responsibility. The newly formed Carton Division is currently purchasing 5,000 tons of pulp per year from a supplier at a cost of £70 per ton, less a 10% quantity discount. Hrubec’s managing director is anxious for the Carton Division to begin purchasing its pulp from the Pulp Division if an acceptable transfer price can be worked out.
Required For Questions 1 and 2 below, assume that the Pulp Division can sell all its pulp to outside customers at the normal £70 price.
1 Are the managers of the Carton and Pulp Divisions likely to agree to a transfer price for 5,000 tons of pulp next year? Why or why not?
2 If the Pulp Division meets the price that the Carton Division is currently paying to its supplier and sells 5,000 tons of pulp to the Carton Division each year, what will be the effect on the profits of the Pulp Division, the Carton Division, and the company as a whole? For Questions 3-6 below, assume that the Pulp Division is currently selling only 30,000 tons of pulp each year to outside customers at the stated £70 price.
3 Are the managers of the Carton and Pulp Divisions likely to agree to a transfer price for 5,000 tons of pulp next year? Why or why not?
4 Suppose that the Carton Division’s outside supplier drops its price (net of the quantity discount) to only £59 per ton. Should the Pulp Division meet this price? Explain. If the Pulp Division does not meet the £59 price, what will be the effect on the profits of the company as a whole?
5 Refer to Question 4 above. If the Pulp Division refuses to meet the £59 price, should the Carton Division be required to purchase from the Pulp Division at a higher price for the good of the company as a whole?
6 Refer to Question 4 above. Assume that due to inflexible management policies, the Carton Division is required to purchase 5,000 tons of pulp each year from the Pulp Division at £70 per ton. What will be the effect on the profits of the company as a whole?

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Selling price 70 Less expenses: Variable 42 Fixed (based on a capacity of 50,000 tons per year) Net profit 18 60 10