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Chapter 6

Q. 6.6

A company that makes large earth-moving machines has a Parts division and an Assembly division. The Parts division supplies the Assembly division with a set of parts that are assembled and sold. The sales price per machine declines because the demand for the machine is sensitive to the final selling price. The following are the costs and company revenues for different levels of output:

Output per week  Parts Division Costs Assembly Division Costs Selling price Per Units Total Revenues Company Profits
1 €100,000 € 50,000 €200,000 €200,000 €50,000
2 180,000 100,000 170,000 340,000 60,000
3 240,000 150,000 160,000 480,000 90,000

What problems will the company encounter if it uses a transfer price of €100,000 per set of parts and allows the manager of the Assembly division to make the choice of how many sets of parts to assemble? The Assembly division manager is evaluated based on divisional profits

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Verified Solution

With a transfer price of €100,000, the following are the profits of the Assembly division:

Output per week  Transfer Cost of Parts Assembly Division  Costs Total Revenues Assembly Division Profit
1  €100,000 € 50,000  €200,000  €50,000
2 200,000 100,000 340,000 40,000
3 300,000 150,000 480,000 30,000

The Assembly division’s profits are highest when it assembles one set of parts per week. The division’s manager, therefore, will choose to assemble one set of parts, even though the company’s profit would be maximized if it made and assembled three sets of parts