SETTING TRANSFER PRICESMARKET PRICE VERSUS FULL COST

Red Deer Electronics Inc. manufactures a variety of printers, scanners, and fax machines in its two divisions: the PSF Division and the Components Division. The Components Division produces electronic components that can be used by the PSF Division. All the components this division produces can be sold to outside customers; however, from the beginning, nearly 90 percent of its output has been used internally.

The current policy requires that all internal transfers of components be transferred at full cost.

Recently, Cam DeVonn, the chief executive officer of Red Deer Electronics, decided to investigate the transfer pricing policy. He was concerned that the current method of pricing internal transfers might force decisions by divisional managers that would be suboptimal for the firm. As part of his inquiry, he gathered some information concerning Component Y34, which is used by the PSF Division in its production of a basic scanner, Model SC67.

The PSF Division sells 40,000 units of Model SC67 each year at a unit price of $42. Given current market conditions, this is the maximum price that the division can charge for Model SC67. The cost of manufacturing the scanner follows:

Component Y34 $ 6.50

Direct materials 12.50

Direct labour 3.00

Variable overhead 1.00

Fixed overhead 15.00

Total unit cost $38.00

The scanner is produced efficiently, and no further reduction in manufacturing costs is possible.

The manager of the Components Division indicated that she could sell 40,000 units (the division's capacity for this part) of Component Y34 to outside buyers at $12 per unit. The PSF Division could also buy the part for $12 from external suppliers. She supplied the following details on the manufacturing cost of the component:

Direct materials $2.50

Direct labour 0.50

Variable overhead 1.00

Fixed overhead 2.50

Total unit cost $6.50

Required:

1. Compute the firm-wide contribution margin associated with Component Y34 and Model SC67. Also, compute the contribution margin earned by each division.

2. Suppose that Cam DeVonn abolishes the current transfer pricing policy and gives divisions autonomy in setting transfer prices. Can you predict what transfer price the manager of the Components Division will set? What should be the minimum transfer price for this part? The maximum transfer price?

3. Given the new transfer pricing policy, predict how this will affect the production decision of the PSF Division manager for Model 5C67. How many units of Component Y34 will the manager of the PSF Division purchase, either internally or externally?

4. Given the new transfer price set by the Components Division and your answer to Requirement 3, how many units ofY34 will be sold externally?

5. Given your answers to Requirements .3 and 4, compute the firm-wide contribution margin. What has happened? Was Cam's decision to grant additional decentralization good or bad?