U.S. Pump is a multidivisional firm that manufactures and installs chemical piping and pump systems. The valve
Question:
U.S. Pump is a multidivisional firm that manufactures and installs chemical piping and pump systems.
The valve division makes a single standardized valve. The valve division and the installation division are currently involved in a transfer pricing dispute. Last year, half of the valve division’s output was sold to the installation division for $40 and the remaining half was sold to outsiders for $60.
The existing transfer price has been set at $40 per pump through a process of negotiation between the two divisions, with the involvement of senior management. The installation division has received a bid from an outside valve manufacturer to supply it with an equivalent valve for $35 each.
The manager of the valve division has argued that if it is forced to meet the external price of $35, it will lose money on selling internally.
The operating data for last year for the valve division are as follows:
Analyze the situation and recommend a course of action. What should installation division managers do? What should valve division managers do? What should U.S. Pump’s senior managers do?
Step by Step Answer:
To provide an analysis of the situation and recommendations lets first summarize the provided information 1 Valve Division sells valves to the Installation Division at 40 each and to external customers at 60 each 2 The outside manufacturer is offering to sell an equivalent valve to the Installation Division at 35 each 3 The Valve Divisions variable cost for producing a valve is 30 Looking at the Valve Divisions operating statement from last year Sales to Installation Division 20000 valves at 40 each results in revenue of 800000 Sales to the outside 20000 valves at 60 each results in revenue of 1200000 The Valve Division secures a gross margin of 65000 from internal sales to the Installation Division and 465000 from external sales The allocated fixed costs are the same for both internal and external sales at 135000 Now lets consider three different perspectives Installation Division Managers Given the outside offer the Installation Division can save 5 per valve 40 35 by switching to the external supplier which could represent a significant cost saving depending on the number of valves used Valve Division Managers The Valve Division currently makes a 10 gross margin per valve sold internally 40 30 If they were forced to match the external price of 35 they would only make a 5 gross margin per valve which would cut their gross margin from internal sales in half However they would still cover their variable cost of 30 and contribute 5 per valve towards fixed costs and profits US Pumps Senior Managers US Pumps senior management should look at the companys overall profitability rather than the profit of individual divisions If the Valve Division refuses to match the external price and the Installation Division sources externally the company would potentially lose the 5 per valve margin contribution that it would have made had the valves been sourced internally They need to ensure that internal transfer prices are set in a way that both divisions are treated fairly and incentivized to support the overall profitability of US Pump Recommendations 1 For the Installation Division it would be costeffective to take the offer from the external supplier if there are no quality or logistical issues However they need to consider the longterm relationship with the Valve Division and the strategic goals of US Pump 2 For the Valve Division they should consider reducing their internal transfer price to match or beat the external bid especially if the alternative is losing the internal customer ...View the full answer
Management Accounting In A Dynamic Environment
ISBN: 9780415839020
1st Edition
Authors: Cheryl S McWatters, Jerold L Zimmerman
