Transfer pricing
Recently, Lindsey took charge of the family farm—Vande Hey Farms. The farm supplies milk in 15-gallons barrels to local grocery stores and farmers’ cooperatives. At the beginning of last year, she decided to put her own stamp on the business by adding an ice-cream unit to the business. The ice cream unit uses milk to produce ice cream. To facilitate control and performance assessment, Lindsey structured each of the two units—the farm and ice cream unit—as a profit center. In other words, the performance of the farm is judged separately from that of the ice cream unit, even though both units belong to the Vande Hey family business. Thus, transfer of milk is not required between the farm and ice cream unit.
Currently, the regular production totals 1000 barrels every quarter; the farm can easily increase production from 1000 to 1,500 barrels, however. For its normal operations and sales, total variable costs to produce each barrel are $19. Each barrel is sold to outside customers for $30. If the farm is to transfer to the ice cream unit, it will avoid packaging and handling charges worth $3.50 per barrel.
The ice cream unit can purchase the same quality of milk from an outside supplier for $27.50 per barrel. To process each barrel of milk to finished ice cream, the unit incurs $14 in processing costs. The selling price for the finished ice cream (the output from one barrel) is $60.
Required: Based on general transfer pricing rule, Assume that the ice cream unit desires 300 barrels for this quarter.
(i) Given the information above (including the fact that the farm has extra capacity), what is the minimum price that the farm should accept to transfer 300 barrels to the ice cream unit?
(ii) Given the information above, what is the maximum price that the ice cream unit should accept for the farm to transfer 300 barrels to its (ice cream) unit?
(iii) How much total profits or loss would the ice cream unit report if it accepts the transfer of 300 barrels at the maximum transfer price in (ii) above?
(iv) If the farm can sell all that it produces to outsider buyers (i.e., there no extra capacity), what is the minimum price the farm should accept to transfer any barrels to the ice cream unit?
(v) How much total profits or loss would the ice cream unit report if it accepts the transfer of 300 barrels at the minimum transfer price under the conditions in (iv) above?