Question

Seedlings, Inc. has two divisions -- Retail and Nursery. The Retail division sells plants and supplies. The Nursery division takes tree seedlings and grows them to healthy young plants before selling the plants internally to the Retail division and to outside commercial customers. The Nursery division's variable costs are $4 per plant, and each plant is sold to outside customers for $6. Each division manager is evaluated based on overall company profit rather than profit produced by each division.

Assume the Nursery division is below capacity and will not sacrifice any sales to outside customers if it sells to the Retail division. What transfer price would you recommend to maximize overall company profit? Be sure to provide sufficient details to support your recommendation.

Assume the Nursery division is at capacity and will sacrifice sales to outside customers if it sells to the Retail division. What transfer price would you recommend to maximize overall company profit? Be sure to provide sufficient details to support your recommendation.

Suppose each division manager is evaluated based on the profit generated within each division rather than overall company profit. What motivational issues might arise related to transfer pricing with this approach to evaluating division managers?

Answer 1

If the Nursery division is below capacity and will not sacrifice any sales to outside customers if it sells to the retail division, the recommended transfer price would be the variable costs per plant as it would ensure that the costs are recovered and the retail division does not have to purchase the plants from an outside vendor at a higher price which would reduce the overall profitability of the company.

If the Nursery division sacrifices sales to outside consumers, then it should sell at the price to outside customers ie. $6. If it sells below that, the profitability of the company would reduce by ($6-$4)=$2 per plant.

If the division managers are evaluated on individual profit, the nursery division would not be willing to sell to the retail division at variable cost. The retail division would not be willing to pay a higher price for the plants.