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 dollar per screen. The SD can sell all its output to the outside market at a price of 100 dollar per screen, after incurring a variable marketing and distribution cost of 8 dollar per screen. If the \(A D\) purchases screens from outside suppliers at a price of 100 dollar per screen, it will incur a variable purchasing cost of 7 dollar 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

1. Minimum Transfer Price for SD Manager

To find the minimum transfer price that the SD manager would be willing to sell screens to the AD, we need to calculate the marginal cost of producing a screen for the SD division. The incremental manufacturing cost, as given in the problem, is 65 dollars per screen. There are no additional costs if the screens are sold internally. Therefore, the minimum transfer price for the SD manager is the marginal cost: Minimum Transfer Price = 65 dollars per screen.

02

2. Maximum Transfer Price for AD Manager

To find the maximum transfer price that the AD manager would be willing to pay for screens from the SD, we need to compare the cost of purchasing screens from outside suppliers and the additional variable purchasing cost. If the AD purchases screens from outside suppliers at a price of 100 dollars per screen, it will incur a variable purchasing cost of 7 dollars per screen: Maximum Transfer Price = External Purchase Price + Variable Purchasing Cost = 100 dollars per screen + 7 dollars per screen = 107 dollars per screen.

03

3a. New Minimum Transfer Price for SD Manager

Now, considering that the SD can only sell 70% of its output capacity of 20,000 screens on the open market, the new minimum transfer price for the SD manager must reflect the cost savings when selling internally instead of externally. In this case, the SD would save on variable marketing and distribution costs (8 dollars per screen): New Minimum Transfer Price = Incremental Manufacturing Cost - Variable Marketing and Distribution Cost Saved = 65 dollars per screen - 8 dollars per screen = 57 dollars per screen.

04

3b. Optimal SD Output Transferred to AD

From Slate's management perspective, the company should aim to maximize its overall operating income. Considering that the AD can sell more than 20,000 TV sets per month, it is in the company's best interest to use the entire output capacity of the SD: Optimal SD Output Transferred to AD = SD Total Output Capacity = 20,000 screens per month.

05

3c. Resulting Transfer Price and Meeting Requirement 3b

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, we can calculate the resulting transfer price as follows: Resulting Transfer Price = (New Minimum Transfer Price for SD + Maximum Transfer Price for AD) / 2 = (57 dollars per screen + 107 dollars per screen) / 2 = 82 dollars per screen. This transfer price balances the interests of both divisions, as it is higher than the new minimum transfer price for SD and lower than the maximum transfer price for AD. By using this price, the company can achieve the desired outcome of utilizing the full production capacity of the SD and selling more than 20,000 TV sets per month in the AD, thus maximizing its overall profitability.

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Key Concepts

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

Incremental Manufacturing Cost

In the context of transfer pricing, understanding the incremental manufacturing cost is crucial. Incremental manufacturing cost refers to the additional cost incurred to produce one more unit of a product. For Slate Company’s screen division, this cost is $65 per screen. This value is fundamental because it helps in determining the minimum transfer price for the Screen Division (SD) to sell screens internally to the Assembly Division (AD). Without any additional costs, the incremental manufacturing cost essentially forms the baseline for internal pricing decisions, ensuring that the SD covers its production cost when entering into internal transactions.
This concept helps ensure that each division covers its minimum necessary costs, fostering financially sound decision-making beneficial to the entire manufacturing process.

Operating Income

Operating income is a key performance measure that Slate's division managers focus on to maximize their profit. It is essentially the profit realized from a business's operations, calculated by subtracting operating expenses from gross profit.
For both SD and AD, the goal is to maximize operating income within their autonomy. The SD wishes to sell products at no less than the incremental manufacturing cost to avoid losses, while the AD aims to procure supplies at competitive rates to ensure maximum profitability.

• The SD's decision to set a minimum price reflects its desire to cover costs and contribute to operating income.
• The AD evaluates supplier cost structures (including external suppliers) to gauge its maximum payable price that still supports optimal operating income.

Overall, achieving a balance between both division's pricing strategies is crucial for ensuring that Slate's operational goals are collectively met.

Capacity Utilization

Capacity utilization at Slate Company is an important consideration because it directly impacts how transfer pricing is decided. Capacity utilization refers to the extent to which a company uses its production capacity. In situations where the SD can only sell 70% of its total capacity, it requires strategic decisions to make full use of available resources.
With excess unsold capacity, internal pricing becomes flexible, allowing for potential price reductions while still enjoying cost savings such as avoided marketing and distribution expenses. The goal is to utilize the full production capacity economically, ensuring resources are not sitting idle and affecting profitability. This is why SD’s new minimum transfer price of $57 per screen is advisable because it accounts for internal sales without incurring distribution costs.

Variable Costs

Variable costs are costs that vary with the level of output. For the SD, variable costs include both the incremental manufacturing cost and the marketing and distribution expenses which amount to $8 per screen when sold externally. These costs directly influence transfer pricing decisions.
On the other hand, the AD considers variable costs involved in purchasing, such as a $7 purchasing fee when dealing with external suppliers. Both divisions must consider these costs when setting their desired transfer prices to ensure they maintain an edge in profitability.

• For the SD, eliminating distribution costs for internal sales lowers the effective price they need to charge the AD.
• For the AD, understanding its variable cost structure aids in determining the maximum feasible price it should agree to in the transaction.

Understanding variable costs helps ensure that both divisions operate efficiently, avoiding unnecessary expenses while optimizing pricing and supply chain considerations.