Question:
A large company is organized into several manufacturing divisions. The policy of the company is to allow the divisional managers to choose their sources of supply and when buying from or selling to sister divisions, to negotiate the prices just as they will for outside purchases or sales. Division X buys all of its requirements of its raw materials R from Division Y. The full manufacturing cost of R for Division Y is Rs. 88 per kg at normal volume. Till recently Division Y was willing to supply R to Division X at a transfer price of Rs. 80 per kg. The incremental cost of R for Division Y is Rs. 76 per kg. Since Division Y is now operating at its full capacity, it is unable to meet the outside customers' demand for R at its market price of Rs. 100 per kg. Division Y, therefore threatened to cut-off supplies to Division X unless the latter agrees to pay the market price for R. Division X is resisting the pressure because its budget based on the consumption of 1,00,000 kg per month at a price of Rs. 80 per kg. is expected to yield a profit of Rs. 25,00,000 per month and so a price increase to Rs. 100 per kg will bring the division close to break-even point. Division X has even found an outside source for a substitute material at a price of Rs. 95 per kg. Although the substitute material is slightly different from R, it would meet the needs of Division X. Alternatively, Division X is prepared to pay Division Y even the manufacturing cost of Rs. 88 per kg.
Required :-
1. Using each of the transfer price of Rs. 80, Rs. 88, Rs. 95 and Rs. 100 show with supporting calculations, the financial results as projected by the Manager of Division X and Manager of Division of Y and the Company.
2. Comment on the effect of each transfer price on the performance of the managers of Division X and Division Y.
3. If you were to make a decision in the matter without regard to the views of the divisional managers, where should Division X obtain its raw materials from and at what price?