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## Q. 6.8

The Kali Company has two divisions. The Paper division makes paper that costs \$1,000 per ton. This division makes 10,000 tons of paper each year, and can either sell all of the paper in the market for \$1,500 per ton, or transfer all of the paper to the Printing division of Kali Company. The Printing division converts the paper into gift wrap at an additional cost of \$4,000 per ton. The gift wrap can be sold for \$5,200 per ton.
a. What is the profit of the company, if all the paper is transferred to the Printing division?
b. What is the profit of the company, if all the paper is sold in the market and the Printing division is closed?
c. How does the use of the market price as the transfer price cause managers of the division to achieve the highest profit for the company?

## Verified Solution

a. The following is the profit of the company if all the paper is transferred to the Printing division:

Revenues (10,000 tons × \$5,200/ton)                        \$52,000,000
Paper costs (10,000 tons × \$1,000/ton)                     (10,000,000)

Printing costs (10,000 tons × \$4,000/ton)                 (40,000,000)
Profit                                                                                    \$ 2,000,000

b. The following is the profit of the company if all the paper is sold in the market and the Printing division is closed:

Revenues (10,000 tons × \$1,500/ton)                        \$15,000,000
Paper costs (10,000 tons × \$1,000/ton)                     (10,000,000)
Profit                                                                                     \$ 5,000,000

c. If the market price of \$1,500 is used as the transfer price, the Printing division’s costs  (\$1,500/ton + \$4,000/ton) will be greater than its revenues (\$5,200/ton). Rather than operating at a loss, the manager can close the Printing division or look for a more profitable opportunity. This example assumes that the costs of the two divisions are opportunity costs and reflect alternative uses of the inputs to the process.