Transfer-pricing dispute. The Kelly-Elias Corporation, manufacturer of tractors and other heavy farm equipment, is organized along decentralized product lines, with each manufacturing division operating as a separate profit center. Each division manager has been delegated full authority on all decisions involving the sale of that division’s output both to outsiders and to other divisions of Kelly-Elias. Division C has in the past always purchased its requirement of a particular tractor-engine component from division A. However, when informed that division A is increasing its selling price to $135, division C’s manager decides to purchase the engine component from external suppliers. Division C can purchase thecomponent for $115 per unit in the open market. Division A insists that, because of the recent installation of some highly specialized equipment and the resulting high depreciation charges, it will not be able to earn an adequate return on its investment unless it raises its price. Division A’s manager appeals to top management of Kelly-Elias for support in thedispute with division C and supplies the following operating data:C’s annual purchases of the tractor-engine component 1,900 unitsA’s variable cost per unit of the tractor-engine component $ 105A’s xed cost per unit of the tractor-engine component $ 251. Assume that there are no alternative uses for internal facilities of division A. Determine whether the company as awhole will benefit if division C purchases the component from external suppliers for $115 per unit. What should thetransfer price for the component be set at so that division managers acting in their own divisions’ best interests take actions that are also in the best interest of the company as a whole?2. Assume that internal facilities of division A would not otherwise be idle. By not producing the 1,900 units for division C, division A’s equipment and other facilities would be used for other production operations that would result in annual cashoperating savings of $22,800. Should division C purchase from external suppliers? Show your computations.3. Assume that there are no alternative uses for division A’s internal facilities and that the price from outsiders drops $15.Should division C purchase from external suppliers? What should the transfer price for the component be set at so thatdivision managers acting in their own divisions’ best interests take actions that are also in the best interest of the companyas a whole?

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Asked Dec 22, 2019
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Transfer-pricing dispute. The Kelly-Elias Corporation, manufacturer of tractors and other heavy farm equipment, is organized along decentralized product lines, with each manufacturing division operating as a separate profit center. Each division manager has been delegated full authority on all decisions involving the sale of that division’s output both to outsiders and to other divisions of Kelly-Elias. Division C has in the past always purchased its requirement of a particular tractor-engine component from division A. However, when informed that division A is increasing its selling price to $135, division C’s manager decides to purchase the engine component from external suppliers. Division C can purchase the
component for $115 per unit in the open market. Division A insists that, because of the recent installation of some highly specialized equipment and the resulting high depreciation charges, it will not be able to earn an adequate return on its investment unless it raises its price. Division A’s manager appeals to top management of Kelly-Elias for support in the
dispute with division C and supplies the following operating data:
C’s annual purchases of the tractor-engine component 1,900 units
A’s variable cost per unit of the tractor-engine component $ 105
A’s xed cost per unit of the tractor-engine component $ 25
1. Assume that there are no alternative uses for internal facilities of division A. Determine whether the company as a
whole will benefit if division C purchases the component from external suppliers for $115 per unit. What should the
transfer price for the component be set at so that division managers acting in their own divisions’ best interests take actions that are also in the best interest of the company as a whole?
2. Assume that internal facilities of division A would not otherwise be idle. By not producing the 1,900 units for division C, division A’s equipment and other facilities would be used for other production operations that would result in annual cashoperating savings of $22,800. Should division C purchase from external suppliers? Show your computations.
3. Assume that there are no alternative uses for division A’s internal facilities and that the price from outsiders drops $15.
Should division C purchase from external suppliers? What should the transfer price for the component be set at so that
division managers acting in their own divisions’ best interests take actions that are also in the best interest of the company
as a whole?

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Expert Answer

Step 1
  1. If there are no alternative uses for internal facilities of division A, it would be detrimental to the company as a whole if division C purchases the component from external suppliers for $115 per unit, because it (the company as a whole) can produce the component for an incremental cost of $105. I believe a fair transfer price for the component be would be:
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S1,900x benefits of |-(S1,900× $25) cost savings (S135-S115), = 38,000 – S47,500 =S-9,500

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Step 2
  1. Division A\'s minimum price will now be:
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Amounts in (S) Particulars Variable manufacturing cost $105 Opportunity cost of making the 1,800 units $22,800 / 1,900 12 Minimum transfer price $117

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Step 3
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It would now be more profitable for division C to buy the motors from the outside supplier and for division A to use its capacity to affect the cost-saving.

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