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Case Assignment: Setting Transfer Prices Market Price vs. Full Cost Re-submit Assignment 

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J. English Electronics Inc. manufactures a variety of printers, scanners, and fax machines in its two divisions: the PSF Division and the Components Division. The Components Division produces electronic components than can be used by the PSF Division. All the components this division produces can be sold to outside customers. However, from the beginning, nearly all of its output has been used internally. The current policy requires that internal transfers of components be transferred at full cost. Recently, Cam DeVonn, the chief executive officer of J. English Electronics, decided to investigate the transfer pricing policy. He was concerned that the current method of pricing internal transfers might force decisions by divisional managers that would be suboptimal for the firm. As part of his inquiry, he gathered some information concerning Component Y34, which is used by the PSF Division in its production of a basic scanner, Model SC67. The PSF Division sells 40,000 units of Model SD67 each year at a unit price of $42. Given current market conditions, this is the maximum price that the division can charge for Model SC67. The cost of manufacturing the scanner follows: Components Y34 Direct materials

$ 6.50 12.50

Direct labor 3.00 Variable overhead Fixed overhead

1.00 15.00

The scanner is produced efficiently, and no further reduction in manufacturing costs is possible. The manager of the Components Division indicated that she could sell 40,000 units (the division's capacity for this part) of Component Y34 to outside buyers at $12 per unit. The PSF Division could also buy the part for $12 from external suppliers. She supplied the following details on the manufacturing cost of the component: Direct materials

$ 2.50

Direct labor 0.50 Variable overhead Fixed overhead

1.00 2.50

Required: 1. Compute the firmwide contribution margin associated with Component Y34 and Model SC67. Also, compute the contribution margin earned by each division. 2. Suppose that Cam DeVonn abolishes the current transfer pricing policy and gives divisions autonomy in setting transfer prices. Can you predict what transfer price the manager of the COmponents Division will set? What should be the minimum transfer price for this part? The maximum transfer price? 3. Conceptual Connection: Given the new transfer pricing policy, predict how this will affect the production decision of the PSF Division manager for Model SC67. How many units of Component Y34 will the manager of the PSF Division purchase, either internally or externally? 4. Given the new transfer price set by the Components Division and your answers to Requirement 3, how many units of Y34 will be sold externally? 5. Conceptual Connection: Given your answers to Requirements 3 and 4, compute the firmwide contribution margin. What has happened? Was Cam's decision to grant additional decentralization good or bad? Required:

1. Compute the firmwide contribution margin associated with Component Y34 and Model SC67. Also, compute the contribution margin earned by each division. Component Y34 Selling Price - Variable Costs = Contribution Margin $6.50 - ($2.50 + 0.50 + 1.00) = $2.50 Model SC67 Selling Price - Variables Costs = Contribution Margin $42 - ($6.50 + 12.50 + 3.00 +1.00) = $19.00 Contribution Margin earned by Component Division Contribution Margin per Unit x Number of units = Contribution margin earned $2.50 x 40,000 units = $100,000 Contribution Margin earned by PSF Division Contribution Margin per Unit x Number of units = Contribution margin earned $19.00 x 40,000 units = $760,000 Firmwide Contribution Margin = CM of Component Division + CM of PSF Division $860,000 = $100,000 + 760,000

2. Suppose that Cam DeVonn abolishes the current transfer pricing policy and gives divisions autonomy in setting transfer prices. Can you predict what transfer price the manager of the Components Division will set? What should be the minimum transfer price for this part? The maximum transfer price? Transfer Price = $12 (because it is the market price) Minimum Transfer Price = $12 (This price is set by selling division) Maximum Transfer Price = $12 (This price is the market price and set by buying division) 3. Conceptual Connection: Given the new transfer pricing policy, predict how this will affect the production decision of the PSF Division manager for Model SC67. How many units of Component Y34 will the manager of the PSF Division purchase, either internally or externally?

If the price of the component Y34 is $12, the PSF Division will incur a loss because the manufacturing cost will increase from $38 to $43.50 which is beyond their selling price. Thus, the PSF Division will choose not to purchase either internally or externally. 4. Given the new transfer price set by the Components Division and your answers to Requirement 3, how many units of Y34 will be sold externally? The Components Division will be able to sell all 40,000 units of the component Y34 externally because $12 is the market price. 5. Conceptual Connection: Given your answers to Requirements 3 and 4, compute the firmwide contribution margin. What has happened? Was Cam's decision to grant additional decentralization good or bad? Sale of Component Y34 Sales - Costs = Contribution Margin (40,000 x $12) - (40,000 x $4) = $480,000 - $160,000 = $320,000 Cam's decision to grant additional decentralization was bad because the Firmwide Contribution Margin decreases by $540,000....