Problem for Self-Study

The Pillercat Corporation is a highly decentralized company. Each division manager has full authority for sourcing decisions and selling decisions. The machining division of Pillercat has been the major supplier of the 2,000 crankshafts the tractor division needs each year.

The tractor division, however, has just announced that it plans to purchase all its crankshafts in the forthcoming year from two external suppliers at $200 per crankshaft. The machining division of Pillercat recently increased its selling price for the forthcoming year to $220 per unit (from $200 per unit in the current year).

Juan Gomez, manager of the machining division, views the 10% price increase as justified. It results from a higher depreciation charge on some new specialized equipment used to manufacture crankshafts and an increase in labor costs. Gomez wants the president of Pillercat Corporation to force the tractor division to buy all its crankshafts from the machining division at the price of $220. The following table summarizes the key data.

Spreadsheet screenshot shows summarized the key data for problem for self-study.

The details are as follows:

  • Number of crankshafts purchased by tractor division: 2000

  • External supplier’s market price per crankshaft: $200

  • Variable cost per crankshaft in machining division: $190

  • Fixed cost per crankshaft in machining division: $20.

Required

  1. Compute the advantage or disadvantage of Juan Gomez’s proposal in terms of annual operating income to the Pillercat Corporation as a whole if the tractor division buys crankshafts internally from the machining division under each of the following cases:
    1. The machining division has no alternative use for the facilities used to manufacture crankshafts.
    2. The machining division can use the facilities for other production operations, which will result in annual cash operating savings of $29,000.
    3. The machining division has no alternative use for its facilities, and the external supplier drops the price to $185 per crankshaft.
  2. As the president of Pillercat, how would you respond to Juan Gomez’s request that you force the tractor division to purchase all of its crankshafts from the machining division? Would your response differ according to the three cases described in requirement 1? Explain.

Solution

  1. 1. Computations for the tractor division buying crankshafts internally for 1 year under cases a, b, and c are as follows:

Spreadsheet screenshot shows computations for the tractor division under cases a, b, and c

Details as follows:

Case a:

  • Number of crankshafts purchased by tractor division: 2,000

  • External supplier’s market price per crankshaft: $200

  • Variable cost per crankshaft in machining division: $190

  • Opportunity costs of the machining division supplying crankshafts to the tractor division: none

  • Total purchase costs if buying from an external supplier (2,000 shafts x $200 per shaft): $400,000

  • Incremental cost of buying from the machining division (2,000 shafts x $190 per shaft): 380,000

  • Total opportunity costs of machining division: none

  • Total relevant costs: 380,000

  • Annual operating income advantage (disadvantage) to Pillercat of buying from the machining division: $20,000

Case b:

  • Number of crankshafts purchased by tractor division: 2,000

  • External supplier’s market price per crankshaft: $200

  • Variable cost per crankshaft in machining division: $190

  • Opportunity costs of the machining division supplying crankshafts to the tractor division: $29000

  • Total purchase costs if buying from an external supplier (2,000 shafts x $200 per shaft): $400,000

  • Incremental cost of buying from the machining division (2,000 shafts x $ 190 per shaft): 380,000

  • Total opportunity costs of machining division: 29,000

  • Total relevant costs: 409,000

  • Annual operating income advantage (disadvantage) to Pillercat of buying from the machining division: (9,000) in parenthesis

Case c:

  • Number of crankshafts purchased by tractor division: 2,000

  • External supplier’s market price per crankshaft: $185

  • Variable cost per crankshaft in machining division: $190

  • Opportunity costs of the machining division supplying crankshafts to the tractor division: none

  • Total purchase costs if buying from an external supplier (2,000 shafts x $185 per shaft): $370,000

  • Incremental cost of buying from the machining division (2,000 shafts x $ 190 per shaft): 380,000

  • Total opportunity costs of machining division: none

  • Total relevant costs: 380,000

  • Annual operating income advantage (disadvantage) to Pillercat of buying from the machining division: (10,000) in parenthesis.

  1. The general guideline that was introduced in the chapter (see section A General Guideline for Transfer-Pricing Situations) as a first step in setting a transfer price can be used to highlight the alternatives:

Spreadsheet screenshot shows transfer price can be used to highlight the alternatives:

Details as follows:

Case a:

  1. Incremental Cost per Unit Incurred to Point of Transfer: $190

  2. Opportunity Cost per Unit to the Supplying Division: $0

  3. Transfer Price(sum of above 1 and 2): $190

  4. External Market Price: $200

Case b:

  1. Incremental Cost per Unit Incurred to Point of Transfer: $190

  2. Opportunity Cost per Unit to the Supplying Division: $14.50 (Opportunity cost per unit = Total opportunity costs ($29,000) divided by Number of crankshafts (2,000) = $14.50)

  3. Transfer Price(sum of above 1 and 2): $204.5

  4. External Market Price: $200

Case c:

  1. Incremental Cost per Unit Incurred to Point of Transfer: $190

  2. Opportunity Cost per Unit to the Supplying Division:

  3. Transfer Price (sum of above 1 and 2): $190

  4. External Market Price: $185.

  1. Comparing transfer price to external-market price, the tractor division will maximize annual operating income of Pillercat Corporation as a whole by purchasing from the machining division in case a and by purchasing from the external supplier in cases b and c.
  2. 2. Pillercat Corporation is a highly decentralized company. If no forced transfer were made, the tractor division would use an external supplier, a decision that would be in the best interest of the company as a whole in cases b and c of requirement 1 but not in case a.
  3. Suppose in case a, the machining division refuses to meet the price of $200. This decision means that the company will be $20,000 worse off in the short run. Should top management interfere and force a transfer at $200? This interference would undercut the philosophy of decentralization. Many top managers would not interfere because they would view the $20,000 as an inevitable cost of a suboptimal decision that can occur under decentralization. But how high must this cost be before the temptation to interfere would be irresistible? $30,000? $40,000?
  4. Any top management interference with lower-level decision making weakens decentralization. Of course, Pillercat’s management may occasionally interfere to prevent costly mistakes. But recurring interference and constraints would hurt Pillercat’s attempts to operate as a decentralized company.