Transfer Pricing with and without Capacity Constraints

Elise Carpets Inc. has just acquired a new backing division that produces a rubber backing, which it sells for $3.30 per square yard. Sales are about 1,200,000 square yards per year. Since the Backing Division has a capacity of 2,000,000 square yards per year, top management is thinking that it might be wise for the companys Tufting Division to start purchasing from the newly acquired Backing Division. The Tufting Division now purchases 600,000 square yards per year from an outside supplier at a price of $3.00 per square yard. The current price is lower than the competitive $3.30 price as a result of the large quantity discounts. The Backing Divisions cost per square yard follows.

Direct materials.......................................................................$1.80

Direct labor...........................................................................0.45

Variable overhead.....................................................................0.37

Fixed overhead (1,200,000 level) .......................................................0.1 5

Total cost.............................................................................$2.77

Required

a. If both divisions are to be treated as investment centers and their performance evaluated by the ROI formula, what transfer price would you recommend? Why?

b. If fixed costs are assumed not to change, determine the effect on corporate profits of making the backing.

c. Based on your transfer price, would you expect the ROI in the Backing Division to increase, decrease, or remain unchanged? Explain.

d. What would be the effect on the ROI of the Tufting Division using your transfer price? Explain.

e. Assume that the Backing Division is now selling 2,000,000 square yards per year to retail outlets.

What transfer price would you recommend? What will be the effect on corporate profits?

f. If the Backing Division is at capacity and decides to sell to the Tufting Division for $3.00 per

square yard, what will be the effect on the companys profits?