The firm is organized into several divisions with divisional managers given the authority to

make virtually all operating decisions. Management control over divisional operations is maintained by a

system of divisional profit and ROI measures which top management reviews regularly. The top

management of Zhoulei Electric has been quite pleased with the effectiveness of the system they have

been using and believe that it is responsible for the company's improved profitability over the last few

years.

The company's Circuit Division manufactures solid$-$state devices and is operating at capacity. The

company's Systems Division has asked the Circuit Division to supply it with $150,000$ units of integrated

circuit IC$378.$ The Circuit Division currently is selling this circuit to its regular customers at a price of $$4$

per unit.

The Systems Division, which is currently operating at only $60$ percent of capacity, wants this particular

circuit for a digital clock system. It has an opportunity to supply $150,000$ of these clock systems to

Centonic Products, a major producer of clock radios and other popular electronic equipment. This is the

first opportunity any of the Zhoulei divisions have had to do business with Centonic Products. Centonic

has offered to pay the Systems Division $$11\mathrm{.}50$ per clock system.

The Systems Division has prepared an analysis of the probable costs to produce the clock system for

Centonic. The division's cost analysis is shown below:

Proposed price per system $.................$ $$11\mathrm{.}50$

Costs, excluding the required integrated circuit

$($IC$378)$ from the Circuit Division:

Components purchased from other suppliers $..................$ $ $4\mathrm{.}20$

Circuit board etchingClabor and variable overhead $.............0\mathrm{.}50$

Assembly, testing, and packingClabor and variable overhead $....0\mathrm{.}70$

Fixed overhead allocation $......................................3\mathrm{.}00$

Profit margin $..................................................0\mathrm{.}60$

$9\mathrm{.}00$

Amount which can be paid for the integrated circuit

$($IC$378)$ from the Circuit Division $.............$ $$2\mathrm{.}50$

The $$2\mathrm{.}50$ amount above that can be paid to the Circuit Division for IC$378$ was determined by working

backwards from the proposed selling price to Centonic. The cost estimates used by the Systems Division

in the above analysis represent the highest amounts that the Systems Division can incur for the various

cost components and still realize a small profit margin.

As a result of this analysis, the Systems Division has offered the Circuit Division a price of $$2\mathrm{.}50$ for each

unit of IC$378.$ Avery Belcher, manager of the Circuit Division, refused this bid because Avery felt that

the Systems Division should at least meet the $$4$ per circuit price that regular customers pay. When the

Systems Division found that it could not obtain a comparable integrated circuit from outside vendors, the

situation was brought to an arbitration committee that has been set up to review such problems.

The arbitration committee prepared an analysis that showed that a price of $$1\mathrm{.}80$ per unit for IC$378$ would

cover the Circuit Division's variable costs of producing the circuit. A price of $$2\mathrm{.}75$ per unit would

Transfer Pricing Case $$ page $2$

cover the division's full costs, including fixed overhead and a price of $$3\mathrm{.}50$ per unit would cover all costs

plus provide a profit margin on each circuit that was equal to the average profit margin on all circuits

produced and sold by the Circuit Division.

Casey Adams, manager of the Systems Division, reacted to the committee's finding by saying, "Avery

Belcher could sell us that integrated circuit for $$2\mathrm{.}50$ per unit and still earn a positive contribution toward

profits. In fact, he should be required to sell at his variable cost,$$1\mathrm{.}80$ per unit, and not be allowed to take

advantage of us$."$

Avery Belcher countered by arguing, $"$It doesn't make sense to sell IC$378$ to the Systems Division for

$$2\mathrm{.}50$ per unit when we can get $$4$ per unit from our regular customers on all we can produce. In fact, the

Systems Division could pay us as much as $$5$ per unit for IC$378,$ and they would still have a positive

contribution to profit. Why should we be forced to subsidize their inability to compete?"

The arbitration committee recommended a price of $$3\mathrm{.}50$ per unit for IC$378$ so that the Circuit Division

could earn a "fair" profit on the business. However, both divisional managers rejected this price.

Consequently, the problem has been brought to the attention of the vice president of operations.

Assignment:

Taking the role of the vice president of operations, write a memo to Casey Adam and Avery Belcher

giving and explaining your decision concerning this transfer pricing dispute. The body of the memo

should not exceed a single page. You may, however, attach $1\mathrm{.}1.$ What transfer price should control the sale of IC$378$ to the Systems Division? What computations

support your Position