91Ó°ÊÓ

The Slate Company manufactures and sells television sets. Its assembly division (AD) buys television screens from the screen division (SD) and assembles the TV sets. The SD, which is operating at capacity, incurs an incremental manufacturing cost of \(\$ 65\) per screen. The SD can sell all its output to the outside market at a price of \(\$ 100\) per screen, after incurring a variable marketing and distribution cost of \(\$ 8\) per screen. If the \(A D\) purchases screens from outside suppliers at a price of \(\$ 100\) per screen, it will incur a variable purchasing cost of \(\$ 7\) per screen. Slate's division managers can act autonomously to maximize their own division's operating income. 1\. What is the minimum transfer price at which the SD manager would be willing to sell screens to the AD? 2\. What is the maximum transfer price at which the AD manager would be willing to purchase screens from the SD? 3\. Now suppose that the SD can sell only \(70 \%\) of its output capacity of 20,000 screens per month on the open market. Capacity cannot be reduced in the short run. The AD can assemble and sell more than \(20,000 \mathrm{TV}\) sets per month. a. What is the minimum transfer price at which the SD manager would be willing to sell screens to the AD? b. From the point of view of Slate's management, how much of the SD output should be transferred to the AD? c. If Slate mandates the SD and AD managers to "split the difference" on the minimum and maximum transfer prices they would be willing to negotiate over, what would be the resulting transfer price? Does this price achieve the outcome desired in requirement 3 b?

Step by step solution

01

Understanding SD's Minimum Transfer Price (1)

When the Screen Division (SD) sells to the outside market, they earn a net price of \(\\(100 - \\)8 = \\(92\). Therefore, the transfer price for selling screens to the Assembly Division (AD) must at least cover this contribution margin of \\)92. The minimum transfer price would thus be \$92.

02

Determining AD's Maximum Willingness to Pay (2)

The Assembly Division (AD) incurs \(\\(100 + \\)7 = \\(107\) when purchasing from an outside supplier. Therefore, the maximum transfer price AD would be willing to pay SD is anything up to \\)107, as it should not exceed the outside purchase cost.

03

SD's Minimum Transfer Price with Excess Capacity (3a)

SD can sell only 70% of 20,000 screens, which is 14,000 screens, to the open market at \\(92 per screen. The remaining 30% of capacity (6,000 screens) only need to cover the incremental manufacturing cost of \\)65. Therefore, for these excess screens, the minimum transfer price is \$65 per screen.

04

Optimizing Output Transfer (3b)

SD should sell 14,000 screens to the outside market and transfer 6,000 screens to AD, as this utilizes full capacity while maximizing income for the company. SD achieves maximum output efficiency, and AD can assemble additional TV sets, benefiting the overall company.

05

Settling on a Compromised Transfer Price (3c)

The range for negotiation is between \\(65 (minimum SD needs for excess capacity) and \\)107 (maximum AD willing to pay). "Splitting the difference" results in a transfer price of \((\\(65 + \\)107)/2 = \$86\). This price allows transfer of the 6,000 excess units.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Incremental Manufacturing Cost

Incremental manufacturing cost refers to the additional cost incurred to produce one more unit of product. For the Screen Division (SD) of The Slate Company, this cost is crucial in determining pricing strategies, especially with the concept of transfer pricing. Each screen has an incremental manufacturing cost of $65, which forms the base requirement for covering costs when selling to the Assembly Division (AD) or the open market.

This cost is different from total manufacturing costs because it only considers the additional expenses directly related to producing more screens. Therefore, when SD has excess capacity, it can afford to lower its transfer prices to just above this cost to ensure at least new-produced screens cover their direct expenses without losing financially.

Capacity Utilization

Capacity utilization measures how well a division or business is using its available production capacity. It's an important concept in the exercise involving The Slate Company since SD is operating at full capacity. When operating at full capacity, a company must decide how to allocate limited resources between internal needs (like supplying AD) and external sales that might bring in higher profits.

If SD has excess capacity, as shown in the example where only 70% of screens can be sold to the open market, they can choose to supply the remaining 30% to AD at a reduced cost, ensuring optimal use of total production capability. Hence, capacity utilization impacts strategic decisions such as pricing and output distribution within the company to maximize overall profits.

Division Autonomy

Division autonomy is the independence given to each division manager to make their own decisions that maximize their division’s operating income. In The Slate Company exercise, both SD and AD managers operate autonomously, which means they decide on transfer pricing based on their division's best interest.

While this autonomy promotes flexibility and encourages managers to closely align with the financial health of their own divisions, it can lead to intra-organizational conflicts if one division's objectives do not align with the company's overall profitability. Balancing such autonomy with overarching corporate goals is critical, as seen in the exercise when settling on transfer prices that benefit the entire Slate Company rather than just individual divisions.

Marginal Cost Analysis

Marginal cost analysis involves examining the cost-effectiveness of producing additional units. In the context of the exercise, when SD has excess capacity, the marginal cost of producing additional screens is essentially the incremental manufacturing cost, which allows them to lower the transfer price to $65 for excess screens sold to AD.

Performing a marginal cost analysis helps in setting transfer prices that can optimize company profits while also accounting for fluctuating production levels. By knowing their marginal costs, the SD can settle on transfer prices that cover expenses and promote cohesive operation within the firm. This form of analysis aids in making informed decisions about production and internal transfers, especially when divisions are tasked to "split the difference" between varying optimal pricing strategies.