The furniture division of Oakwood Furnishings purchases lumber and makes tables, chairs and other wood furniture. Most of the lumber is purchased from the Joshua Creek Mill, also a division of Oakwood Furnishings. The furniture division and Joshua Creek Mill are profit centres.

The furniture division manager proposed a new chair that will sell for $250.00. The manager wants to purchase the lumber from Joshua Creek Mill. Production of 800 chairs is planned, using capacity in the furniture division that is currently idle.

The furniture division can purchase the lumber for each chair from an outside supplier for $90.00. Oakwood Furnishings has a policy that internal transfers are priced at variable cost, plus allocated fixed costs.

Assume the following costs for the production of one chair:

Joshua Creek Mill

Variable costs $80.00

Allocated fixed cost 30.00

Fully absorbed costs $110.00

Furniture Division

Variable costs:

Lumber, Joshua Creek Mill $110.00

Furniture division variable costs:

Manufacturing 45.00

Selling 10.00

Required:

1. Assume that the Joshua Creek Mill has idle capacity and would incur no additional fixed costs to produce the required lumber. Would the furniture division manager buy the lumber for the chair from the Joshua Creek Mill, given the existing transfer pricing policy? Why or why not?

2. Calculate the contribution margin for the company as a whole if the manager decides to buy from Joshua Creek Mill and is able to sell 800 chairs.

3. What transfer price policy would you recommend if the Joshua Creek Mill always has excess capacity? Explain why this transfer price policy provides incentives for the managers to act in the best interests of the company as a whole.

4. Explain how the excess capacity affects the recommendation in part 3.