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Transfer price

The Canadian Instruments Company uses the decentralized form of organizational structure and considers each of its divisions as an investment center. The Toronto Division is currently selling 15,000
air filters annually, although it has sufficient productive capacity to produce 21,000 units per year.
Variable manufacturing costs amount to $21 per unit, while the total fixed costs amount to $90,000.
These 15,000 air filters are sold to outside customers at $40 per unit.

The Montreal Division, also a part of Canadian Instruments, has indicated that it would like to
buy 1,500 air filters from the Toronto Division, but at a price of $37 per unit. This is the price the
Montreal Division is currently paying an outside supplier.

1. Compute the effect on the operating income of the company as a whole if the Montreal Division
purchases the 1,500 air filters from the Toronto Division.

2. What is the minimum price that the Toronto Division should be willing to accept for these 1,500
air filters?

3. What is the maximum price that the Montreal Division should be willing to pay for these 1,500 air
filters?

4. Suppose instead that the Toronto Division is currently producing and selling 21,000 air filters
annually to outside customers. What is the effect on the overall Canadian Instruments Company
operating income if the Toronto Division is required by top management to sell 1,500 air filters to
the Montreal Division at (a) $21 per unit and (b) $37 per unit?

5. For this question only, assume that the Toronto Division is currently earning an annual operating
income of $36,000, and the division's average invested capital is $300,000. The division
manager has an opportunity to invest in a proposal that will require an additional investment
of $20,000 and will increase annual operating income by $2,000. (a) Should the division manager
accept this proposal if the Canadian Instruments Company uses ROI in evaluating the
performance of its divisional managers? (b) If the company uses economic profit? (Assume a
cost of capital of 7%.)

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