US Pumps is a multidivisional firm that manufactures and installs chemical pipin
ID: 2434353 • Letter: U
Question
US Pumps is a multidivisional firm that manufactures and installs chemical piping and pump systems. Its valve division makes a single standardized valve. The valve division and installation division currently are involved in a transfer-pricing dispute. Last year, half of the valve division’s output was sold to the installation division for $40 and the remaining half was sold to outsiders for $60.The existing transfer price of $40 per pump has been set through a negotiation process between the two divisions and with the involvement of senior management. The installation division has received a bid from an outside value manufacturer to supply it with an equivalent valve for $35 each.
The valve’s division’s manager has argues that if it is forced to meet the external price of $35 it will l ose money on internal sales.
The operating data for the last year for the valve division follow:
Valve Division
Operating Statement-Last year
To Installation Division To Outside
Salas 20k@ $40 $800,000 20,000 @ $60
$1,200,000
Variable cost @ $30 (600,000) (600,000)
Fixed Cost (135,000) (135,000)
Gross margin $ 65,000 $465,000
Analyze the situation and recommend a course of action. What should the installation division managers do? What should the valve division managers do? In your opinion, what should the US Pumps senior manager do?
Explanation / Answer
If you assume that the intercompany sales of the 20,000 valves will just go away if the installation division buys them externally, the division and the company as a whole would be better off dropping the transfer price to $35. This is because even though the division has a net loss on its internal sales at $35, the division is making a variable margin of $5 that can offset a portion of its fixed costs. In reality, the question is how many of those 20,000 could be sold externally, and how would that affect the price of the 20,000 now being sold at $60. If demand was fairly elastic, and you wouldn't have to drop the price too much, you might be better off selling all externally and having the other division buy from outside. Of course this begs the question of how the division is able to buy outside for $35 what it can sell for $60. If it were a company with a good name and an established sales channel and the other company was a new one, I could see some price difference. Not that much, though.
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