Reference no: EM132562054

In a large paper-making company there are several divisions, each of which is a complete profit center. The cardboard division produces coated cardboard to be sold to large food producers in the market. They are by far the biggest producer of coated cardboard in their market area. Accountants of the cardboard division have found that there is a clear relationship between sales price and possible sales volumes. To be precise, they have found the following relationship between price and volume in Table 1:

Table 1 Price Volume Relationship Price ($/ton) 1400 1600 1800 2000 Volume (tons) 58000 42000 31000 24000 In the following case we shall disregard the possibility of charging prices between those mentioned in the table. Product costing In the beginning of the case all internal transfer prices are equal to the full cost of the supplier. Under those circumstances, the product costs for 1 ton of coated cardboard are as in Table 2. Paper pulp and coating chemicals are bought from two other divisions within the same group. Internal transfer prices have been suggested by the top management. The product costs of those supplies have been worked out for 1 ton of coated cardboard, as in Table 3. The paper pulp division is working at full capacity and they have a very large market for their products. In the case of lower internal demand, they can easily sell the remaining volumes at list price in the external market.

Table 2 Product costs per ton of coated cardboard

Direct materials:

Paper pulp $500

Coating chemicals 150

Other material 100

Direct wages 100

Allocated fixed costs 400

Full costs ($/ton) 1250

Table 3 Product costs of pulp and chemicals per ton of coated cardboard Paper pulp Coating chemicals

Direct materials $300 $50

Direct wages 50 50

Allocated fixed costs 150 50

Full cost 500 150

Suggested transfer price 600 200

External list price 750 250

The chemicals division, on the other hand, has surplus capacity. If they do not increase their sales soon, they will have to get rid of capacity as well as personnel.

Question 1. Comment on the optimal market price and volume for coated cardboard with all given volumes in Table 1. Briefly explain how decisions might change and what would happen to the total profit of the entire group. Assuming transfer pricing to be

a. 150% of full cost

b. Market price based

c. Suggested transfer price based (paper pulp at $600 and chemicals at $200)

Question 2. Since the chemical division has surplus capacity, their external list price is not quite relevant for internal pricing. Comment on the lower price limit per unit of the chemicals sold internally by the chemical division. Briefly explain how the decisions might change and what would happen to the total profit of the entire group.

Question 3. On the basis of above analysis, create rule for optimal transfer pricing referring to 'direct costs' and 'opportunity costs'.