The Tortrac Corporation - Transfer Pricing

ASSIGNMENT                                         * Transfer Pricing *                                                    

The Tortrac Corporation is a highly decentralized company. Each division manager has full authority for sourcing decisions and selling decisions. The tractor division (T-Division) buys crankshafts from the machining division (M-Division).

The M-Division, which is operating at capacity, incurs an incremental manufacturing cost of $196 per crankshaft.  The M-Division can sell all its output to the outside market at a price of $300 per crankshaft, after incurring a variable marketing and distribution cost of $ 24 per crankshaft. If the T-Division purchases crankshafts from outside suppliers at a price of $300 per crankshaft, it will incur a variable purchasing cost of $22 per crankshaft. Tortrac’s division managers can act autonomously to maximize their own division’s operating income.  

Required

2.1   What is the minimum transfer price at which the M-Division manager would be willing to sell crankshafts to the T-Division?  (6pt)

The minimum transfer price that the M-Division would demand from the T-Division is the net price it could obtain from selling its crankshafts on the outside market:

$300 minus $24 marketing and distribution cost per crankshaft, or $276 per crankshaft.

The M-Division is operating at capacity. The incremental cost of manufacturing each crankshaft is $196. Therefore, the opportunity cost of selling a crankshaft to the T-Division is the contribution margin the M-Division would forego by transferring the crankshaft internally instead of selling it on the outside market.

        Contribution margin per crankshaft = $276 – $196 = $80

Using the general guideline:

Minimum transfer price per crankshaft = Incremental cost per crankshaft + Opportunity cost per crankshaft =

                = $196 + $80 = $276   (3+3pt)

2.2   What is the maximum transfer price at which the T-Division manager would be willing to purchase crankshafts from the M-Division?  (4pt)

The maximum transfer price the T-Division manager would be willing to offer M-Division is its own total cost for purchasing from outside, $300 (2pt) plus $22 (2pt) per crankshaft, or $322 per crankshaft.

2.3   Now suppose that the M-Division can sell only 75% of its output capacity of 30,000 crankshafts per month on the open market. Capacity cannot be reduced in the short run. The T-Division can produce and sell more than 30,000 tractors per month.

1. What is the minimum transfer price at which the M-Division manager would be willing to sell crankshafts to the T-Division? (6pt)

If the M-Division has excess capacity (relative to what the outside market can absorb), the minimum transfer price using the general guideline is:

• for the first 7,500 units (or 25% of output), $196 (3pt) per crankshaft because opportunity cost is zero;
• for the remaining 22,500 units (or 75% of output), $276 per crankshaft (3pt) because opportunity cost is $80 per crankshaft.

1. From the point of view of Tortrac’s management, how much of the M-Division output should  be transferred to the T-Division? (6pt)

From the point of view of Tortrac’s management, all of the M-Divisions’s output should be transferred to the T-Divions. (2pt) This would avoid the $ 22 per crankshaft variable purchasing cost that is incurred by the T-Division when it purchases crankshafts from the outside market (2pt) and it would also save the $24 (2pt) marketing and distribution cost the M-Division would incur to sell each crankshaft to the outside market.