Transfer Pricing The shocks and struts division of Transnational Motors Company

Question

Transfer Pricing

The shocks and struts division of Transnational Motors Company produces strut assemblies for automobiles. It has been the sole supplier of strut assemblies to the automotive division and charges $45 per unit, the current market price for very large wholesale lots. The shocks and struts division also sells to outside retail outlets, at $57 per unit. Normally, outside sales amount to 25% of a total sales volume of 1 million strut assemblies per year. Typical combined annual data for the division follow:

Flint Auto Parts Company, an entirely separate entity, has offered the automotive division comparable strut assemblies at a firm price of $42 per unit. The shocks and struts division of Transnational Motors claims that it cannot possibly match this price because it could not earn any margin at $42.

1. Assume that you are the manager of the automotive division of Transnational Motors. Comment on the shocks and struts division's claim. Assume that normal outside volume cannot be increased.

2. Now assume the shocks and struts division believes that it can increase outside sales by 750,000 strut assemblies per year by increasing fixed costs by $3 million and variable costs by $4.50 per unit while reducing the selling price to $54. Assume that maximum capacity is 1 million strut assemblies per year. Should the division reject intracompany business and concentrate on outside sales?

Sales $48,000,000 Variable costs, at $37.50 per strut assembly $37,500,000 Fixed costs 4,500,000 Total costs $42,000,000 Gross margin $6,000,000

Explanation / Answer

1) The present contribution margin for the Shock and Strutts division is

It is given that the retail sales cannot be increased, which means that there is spare capacity for the S&S division. Only 25% can be sold outside throught retail and the balance has to be consumed internally. Hence, the 75% of capacity can be considered as spare capacity.

If the Automotive division gets its entire requirement externally, then the S&S division will have idle capacity to the extent of 75%. Under such a situation the minimum price that the S&S division can accept is the Marginal Cost of $37.5 per unit.

The price offered by the external supplier of $42 is higher than the marginal cost of S&S division of $37.5. If the transfer price is fixed at $42, the S&S division would get a contribution of $4.5 per unit. Hence, the claim of the S&S division that it has no margin is not correct.

2) Yes, the S&S division should reject the intracompany business and concentrate on ouside sales as its profits would increase by $7,500,000, as shown below: This is after assuming that it charges only $42 to the Automotive division.

Further, the company as a whole (Transnational Motors), stands to gain by getting the requirement of the Automotive division from external sources @ $42 ($4.5 per unit higher than the variable cost of S$S division before operational restructure), thereby allowing the S&S division to make a realisable contribution of $13 per unit.

Alt I Alt II no of units produced & sold/transferred 1000000 1000000 sales    at $54 per unit 54000000    at $57 for 25% and $42 for 75%) 45750000 variable cost at = 37.5+4.5=42 42000000                            at 37.5 37500000 contribution margin 8250000 12000000 fixed costs 4500000 7500000 operating profit 3750000 4500000 Alt I - supplying the automotive division @ $42 Alt II - selling all the units externally after restructuring operations.

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