Transfer Pricing

Milk Products is a dairy farm located in the Midwest. The dairy farm has two divisions, milk and cheese. Both divisions generate revenues and costs and, as such, are treated as profit centers. Jordyn is in charge of the milk division, which has fixed costs of $50,000 a month and variable costs of $1.50 per gallon of milk. The milk division produces 200,000 gallons of milk each month. Austin manages the cheese division and uses 1 gallon of milk from Jordyns cows to make a block of cheese. The process of converting milk to cheese requires variable costs of $5 per block in addition to $20,000 fixed costs. The amount of cheese Austin sells is based on how much he charges for each block, as follows: Block price Blocks sold $10 $5,000 $11 $4,500 $12 $4,000 $13 $3,500 $14 $3,000 $15 $2,500 Jordyn can sell milk externally for $2.25 per gallon. Jordyn and Austin have been fighting over the price of milk. Jordyn thinks Austin should pay her $2.25 per gallon and Austin thinks he should pay $1.50 per gallon. Please do the following:

a) How many blocks of milk Austin will choose to produce and sell if transfer price is $1.50.

b) How many blocks of milk Austin will choose to produce and sell if transfer price is $2.25.

c). Which price is better for the firm and why? Also, what should happen if Jordyn can sell all her milk externally for $2.25?

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