West Island Products

Question

Determine a transfer price that would meet Danielson's stated requirement regarding financial evaluation of the Office Division.

Background

West Island Products (WIP) is a furniture manufacturing company founded in the 1970's. Originally, WIP was focused only on producing furniture for use in homes. The organization was successful in producing furniture for this market and gained a reputation for making quality products at good prices. WIP is based in Ithaca, New York, and sold their home furniture to retail furniture stores in the northeast area of the United States. Transportation costs for furniture from the WIP factory to retail stores meant that trying to expand geographically was difficult as the local furniture manufacturers in other regional markets would not face these costs.

In 2010 the founder of WIP had reached a point where he wished to retire. John Smith, the manager in charge of production at WIP, approached a venture capital organization to fund the purchase of WIP from the founder. The venture capital firm was interested in this opportunity as Smith presented ideas for expansion that could also be funded by that investment firm. Specifically, Smith had identified two new product categories for WIP's expansion: office furniture and restaurant furniture. Both of these markets required specialized furniture and Smith was confident that WIP could be successful in both channels.Under Smith as the new president of WIP, the acquisition of WIP by the venture capital firm was completed in 2010 and further capital was invested to fund the expansion.

In 2011 and 2012 WIP expanded manufacturing facilities and equipment in order to make the larger variety of products required to compete in the three market segments in which WIP was now focused. Smith also decided to create three divisions within WIP, each focused on one of the target markets (i.e., home furniture, office furniture, and restaurant furniture). The divisions were autonomous, with each division responsible for its own sales, production (due to the use of dedicated types of equipment for each category of furniture), cost of operations, and production equipment acquisition. Divisional performance was evaluated annually based on return on investment (ROI). Because the markets and products of the divisions are weredifferent, there have never been any transfers between divisions.

Transfer Possibility

The Office Division of WIP is managed by Nathan Danielson. Among the products manufactured by the Office Division are two models of stools: the Deluxe Office Stool and the Economy Office Stool (see Exhibit 3). Both of these stools consist of two separate components: a steel frame and a seat. The Deluxe Office Stool uses a cushioned seat while the Economy Office Stool uses a molded plastic seat. The Office Division manufactures the steel frames for both the stools. It also manufactures the cushioned seat for the Deluxe Office Stool, but it purchases the molded seat for the Economy Office Stool from an outside supplier. In order to complete either stool, the seats and the frame have to be assembled to make the final products.

The Restaurant Division manufactures and markets the furniture that is purchased by the restaurant industry. Roberta Katz is the Restaurant Division manager. In early 2015, the division was working on plans to introduce a new line of bar stools. The proposed bar stool would also be assembled from two separate components: a metal frame and a cushioned seat. Katz believedthat these new stools could be successful. To date, the Restaurant Division had never produced furniture that required cushioned seats. Rather than try to design and build such a seat internally within the Restaurant Division, Katz wondered if theseat already produced by the Office Division for the Deluxe Office Stool could be adapted to her needs.

Katz approached Danielson with her idea and to discuss the possibility of the two divisions collaborating. Both Katz and Danielson noted that there were no previous examples of this sort of collaboration to use as a precedent. After some discussion, they both concluded that the cushioned seat currently made by the Office Division for use on the Deluxe Office Stool could be modified for use on the bar stools. Consequently, Katz asked Danielson for a price for 100-unit lots of the cushioned seats. The following conversation took place about the price to be charged for the cushioned seats.

Danielson:"Roberta, we can make the necessary modifications to our current cushioned seat easily. The raw materials used in the cushioned seat for your bar stool are slightly different and should cost about 10 per cent more than those used in for our Deluxe Office Stool. However, the labor time should be the same because the seat fabrication process is the same. I would price the seat at our regular rate: full cost plus a 30 per cent mark-up. According to my calculations, that would be $2,053 per lot of 100 seats."

Katz:"That's higher than I expected, Nathan. I was thinking that a good price would be your variable manufacturing cost. After all, your fixed costs will be incurred regardless of this job. In addition, I have received a quotation from one of the RestaurantDivision's regular suppliers to provide us with the bar stool seats at $1,900 per lot of 100 seats."

Danielson:"Roberta, I am at capacity. By making the cushioned seats for you, I have to cut my production of Deluxe Office Stools because the workers who make the cushion seats for that model have specialized skills. With the cut in production of Deluxe Office Stools, I would shift the labor time freed-up by not having to fabricate the frame and assemble the Deluxe Office Stool to the production of more Economy Office Stools. I don't mind changing my product mix to the economy model as long as long as it does not negatively affect my division's financial evaluation. Here are my standard costs for the two stools and a schedule of my manufacturing overhead." (See Exhibits 1 and 2.)

Katz:"I guess I see your point, Nathan, but I don't want to price myself out of the market. In addition to pricing, I am also concerned about delivery. We'll need the bar stools within two weeks of placing our order or we risk losing some important potential customers. Our outside supplier claims that they can meet our timing needs."

Danielson:"Oh-oh. That lead-time is a bit short considering the production re-scheduling we need to do. I can't promise you a lead-time shorter than four weeks at the moment."

Katz:"There's quite a few issues that need to be addressed here, Nathan. As we have no previous experience in transferring goods between our divisions, I think we should speak with John Smith before we can go any farther in our negotiations."

Exhibit 1 - Office Division Standard Costs and Prices

	Deluxe Office Stool		Economy Office Stool
Direct materials:
Frame	$ 7.35		$ 6.50
Cushioned seat	6.40
Molded seat (purchased)			6.00
Direct Labor:
Frame fabrication (0.5 hrs. @ $7.50/hr.)	3.75		3.75
Cushion seat fabrication (0.5 hrs. @ $7.50/hr.)	3.75
Assembly (cushion to frame) (0.5 hrs. @ $7.50/hr.)	3.75		3.75
Manufacturing overhead ($10.00/DLH)	15.00		10.00
Total standard full cost	$ 40.00		$ 30.00
Selling price (including 30% mark-up)	$ 52.00		$ 39.00

Exhibit 2 - Office Division Manufacturing Overhead Budget

Overhead Item	Description	Amount
Supplies	Variable	$ 370,000
Indirect labor	Variable	375,000
Supervision	Fixed	150,000
Power	Variable	180,000
Heat and light	Fixed	120,000
Property tax & insurance	Fixed	130,000
Depreciation	Fixed	1,100,000
Employee benefits	Variable	575,000
	Total overhead	$3,000,000
	Capacity in direct labor hours (DLH)	300,000
	Overhead rate per direct labor hour	$ 10.00