Problem - Turner Energy is a decentralized oil exploration, production, and refining company located in Texas. Currently, the company's Transportation division has one pipeline that transfers 10,000 barrels per day of crude oil from Turner-owned wells in the Permian Basin to the Refining division outside Houston. The Refining division also purchases 20,000 barrels of crude oil per day from Arabella E&P, another local crude oil producer; Arabella delivers the crude directly to the refinery. The pipeline can transfer up to 40,000 barrels of crude per day, and the refinery can process up to 30,000 barrels of crude into gasoline each day. Currently, the Refining division purchases crude oil from Arabella for $57 per barrel, and sells gasoline for $127 per barrel. Additional cost information for the Transportation division is provided in the table below.
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Turner Petroleum Transportation Division Cost Summary
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Internally-provided crude cost
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$48 per barrel
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Cost to transport crude to refinery
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$1 per barrel
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Daily fixed costs
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$120,000
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Required:
1. Suppose that Turner Energy uses a markup of 5% over full cost to set transfer prices. What price will the Transportation division charge the Refining division for crude oil if Turner uses actual transportation levels to allocate fixed costs? What price will the Transportation division charge the Refining division if Turner uses capacity transportation levels to allocate fixed costs? Which approach do you recommend? Why?
2. Turner has identified an opportunity to replace the existing 20,000 barrels of crude it purchases from Arabella with crude from an alternative supplier, Cornerstone. The Transportation division will purchase crude oil from Cornerstone, who will provide the crude oil to the Transportation division in the Permian Basin. The Transportation division will then transport the crude oil to the Refining division. Cornerstone has offered to sell the crude oil to Turner for $52 per barrel. Assume that Turner will apply the standard full-cost plus 5% markup for transfer prices. Clearly state the base you choose for allocating fixed costs.
a. What is the incremental benefit or cost to Turner Energy, as a whole, of switching from Arabella to Cornerstone to supply the crude?
b. What is the incremental benefit or cost to the Transportation division of switching from Arabella to Cornerstone to supply the crude?
c. What is the incremental benefit or cost to the Refining division of switching from Arabella to Cornerstone to supply the crude?
d. At what transfer price would the Transportation division be indifferent between transferring crude oil from Cornerstone to the Refining division, and Arabella directly supplying crude oil to the Refining division?
e. Why do the divisions' goals not necessarily align with those of the company as a whole in this case?
f. How would you recommend the transfer price be set? Would you intervene to force a different transfer price, if you were the VP of operations? Why or why not?
3. Suppose Turner's controller has also identified an opportunity to transfer crude oil on behalf of another company, IDST Oil. IDST has asked Turner to transport up to 30,000 barrels of crude oil from Turner's location in the Permian Basin to Turner's refinery outside Houston. IDST would then collect the crude oil from Turner's refinery and transport it to their own refinery. ISDT has offered to pay $3.50 per barrel for transportation. Supposing the Transportation division would transport enough IDST crude oil to fulfill capacity, at what transfer price would the Transportation division be indifferent between transferring crude oil from Cornerstone to the Refining division, and Arabella directly supplying crude oil to the Refining division?