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Transfer Pricing

Determine whether the Cole Division should sell motors to the Diamond Division at the prevailing market price, or accept the Wales Company contract. Support with appropriate calculations.

Robert Products Inc. consists of three decentralized divisions: Bayside Division, Cole Division, and Diamond Division. The president of Robert Products has given the managers of the three divisions authority to decide whether to sell outside the company or among themselves at an internal price determined by the division managers. Market conditions are such that sales made internally or externally will not affect market or transfer prices. Intermediate markets will always be available for Bayside, Cole, and Diamond to purchase their manufacturing needs or sell their product.

The manager of the Cole Division is currently considering the two alternative orders presented below.

? The Diamond Division is in need of 3,000 units of a motor that can be supplied by the Cole Division. To manufacture these motors, Cole would purchase components from the Bayside Division at a price of $600 per unit; Bayside's variable cost for these components is $300 per unit. Cole Division will further process these components at a variable cost of $500 per unit.
? If the Diamond Division cannot obtain the motors from Cole Division, it will purchase the motors from London Company which has offered to supply them to Diamond at a price of $1,500 per unit. London Company would also purchase 3,000 components from Bayside Division at a price of $400 for each of these motors; Bayside's variable cost for these components is $200 per unit.
? The Wales Company wants to place an order with the Cole Division for 3,500 similar motors at a price of $1,250 per unit. Cole would again purchase components from the Bayside Division at a price of $500 per unit; Bayside's variable cost for these components is $250 per unit. Cole Division will further process these components at a variable cost of $400 per unit.

The Cole Division's plant capacity is limited, and the division can accept either the Wales contract or the Diamond order, but not both. The president of Robert Products and the manager of the Cole Division agree that it would not be beneficial in the short or long run to increase capacity.

Solution Preview

Analyze the contribution margin for Cole for each of the two alternatives since this will allow one to determine how much money will be left over to cover the fixed costs (with the remainder being operating income).
Contribution margin = Sales (internal or external) - Variable costs
Operating income = Contribution margin - Fixed costs

First scenario: Sell motors to Diamond division
Since Diamond can buy ...

Solution Summary

This solution looks at transfer pricing and strategy of a company with three decentralized divisions.

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