Sky Armour Industries manufactures high-grade aluminum luggage made from recycled metal. The company operates two divisions: metal recycling and luggage fabrication. Each division operates as a decentralized entity. The metal recycling division is free to sell sheet aluminum to outside buyers, and the luggage fabrication division is free to purchase recycled sheet aluminum from other sources. Currently, however, the recycling division sells all of its output to the fabrication division, and the fabrication division does not purchase materials from any outside suppliers.
Aluminum is transferred from the recycling division to the fabrication division at 110% of full cost. The recycling division purchases recyclable aluminum for $0.50 per pound. The division’s other variable costs equal $2.80 per pound, and fixed costs at a monthly production level of 50,000 pounds are $1.50 per pound. During the most recent month, 50,000 pounds of aluminum were transferred between the two divisions. The recycling division’s capacity is 70,000 pounds.
Due to increased demand, the fabrication division expects to use 60,000 pounds of aluminum next month. Metalife Corporation has offered to sell 10,000 pounds of recycled aluminum next month to the fabrication division for $5.00 per pound.
Calculate the transfer price during the most recent month per pound of recycled aluminum.
Assuming that each division is considered a profit center, would the fabrication manager choose to purchase 10,000 pounds next month from Metalife?
Is the purchase in the best interest of Sky Armour Industries? Show your calculations.
What is the cause of this goal incongruence?
The fabrication division manager suggests that $5.00 is now the market price for recycled sheet aluminum and that this should be the new transfer price. Sky Armour Industries’ corporate management tends to agree. The metal recycling manager is suspicious. Metalife’s prices have always been considerably higher than $5.00 per pound.
Why the sudden price cut? After further investigation by the recycling division manager, it is revealed that the $5.00 per pound price was a one-time-only offer made to the fabrication division due to excess inventory at Metalife. Future orders would be priced at $5.50 per pound.
Elaborate on the validity of the $5.00 per pound market price and the ethics of the fabrication manager.
Would changing the transfer price to $5.00 matter to Sky Armour Industries?
Full Answer Section
- Offer from Metalife: $5.00 per pound
Since $5.00 (Metalife) is less than $5.28 (Recycling Division), the fabrication manager would choose to purchase the 10,000 pounds from Metalife, as it is the cheaper option for their division.
3. Is the purchase in the best interest of Sky Armour Industries? Show your calculations.
To determine if the purchase is in the best interest of Sky Armour Industries as a whole, we need to consider the company's total costs and lost opportunities.
Scenario A: Fabrication purchases 10,000 pounds from Metalife.
- Recycling Division's current operation: The recycling division's capacity is 70,000 pounds. They currently transfer 50,000 pounds to fabrication.
- The fabrication division needs 60,000 pounds. If they buy 10,000 pounds from Metalife, they will buy 50,000 pounds from the Recycling Division.
- Cost to Sky Armour Industries (from Recycling Division's perspective):
- For the 50,000 pounds transferred internally: The relevant cost to the company is the recycling division's variable cost as fixed costs are incurred regardless.
- Variable Cost per pound = $0.50 (purchase) + $2.80 (other variable) = $3.30
- Cost for 50,000 pounds from Recycling = 50,000 lbs * $3.30/lb = $165,000
- Cost for 10,000 pounds from Metalife: 10,000 lbs * $5.00/lb = $50,000
- Total Cost to Sky Armour Industries (Scenario A): $165,000 (internal variable) + $50,000 (external purchase) = $215,000
Scenario B: Fabrication purchases all 60,000 pounds from the Recycling Division.
- The Recycling Division's capacity is 70,000 pounds, so they can produce the additional 10,000 pounds.
- Relevant cost to Sky Armour Industries for the additional 10,000 pounds: Only the variable costs incurred by the recycling division, as they have excess capacity and no opportunity cost of lost external sales.
- Variable Cost per pound = $3.30
- Total Cost to Sky Armour Industries (Scenario B):
- Cost for 60,000 pounds from Recycling = 60,000 lbs * $3.30/lb = $198,000
Comparison:
- Cost if purchase from Metalife: $215,000
- Cost if purchase internally: $198,000
The purchase from Metalife is NOT in the best interest of Sky Armour Industries. The company would incur an additional cost of $17,000 ($215,000 - $198,000) by purchasing from Metalife instead of utilizing its own recycling division's excess capacity.
4. What is the cause of this goal incongruence?
The cause of this goal incongruence is the use of a full-cost-plus transfer pricing method combined with decentralized profit centers and the availability of excess capacity in the supplying division.
- Full-Cost-Plus Transfer Pricing: The transfer price of $5.28 (110% of full cost) is higher than the Metalife offer ($5.00), making the internal purchase appear more expensive to the fabrication division manager. However, the relevant cost to the company for the additional 10,000 pounds from the recycling division is only its variable cost ($3.30), because the fixed costs are already covered by the initial 50,000 pounds of production, and there are no external sales being foregone.
- Decentralized Profit Centers: Each division manager is incentivized to maximize their own division's profit. The fabrication manager makes a decision that is rational for their division's profitability, but this leads to a sub-optimal outcome for the entire company.
- Excess Capacity: Because the recycling division has unused capacity (70,000 lbs capacity - 50,000 lbs current production = 20,000 lbs excess capacity), the marginal cost of producing the additional 10,000 pounds is only the variable cost. The full-cost transfer price does not reflect this marginal cost.
The transfer pricing mechanism is leading to a decision that benefits one division at the expense of overall corporate profitability.
5. Elaborate on the validity of the $5.00 per pound market price and the ethics of the fabrication manager.
Validity of the $5.00 per pound market price: The $5.00 per pound price offered by Metalife, initially presented as a "market price" by the fabrication manager, is not a valid long-term market price. It is revealed to be a one-time-only offer due to excess inventory at Metalife, with future orders priced at $5.50 per pound. A true market price reflects the ongoing, typical transaction price for a good or service in a competitive market, driven by stable supply and demand conditions. A temporary, discounted offer due to a seller's specific inventory situation does not represent the general market rate. The recycling division manager's suspicion was well-founded.
Ethics of the fabrication manager: The fabrication manager's ethics are questionable in this scenario.
- Misrepresentation: By suggesting that $5.00 is "now the market price" when it was a known one-time offer, the fabrication manager engaged in misrepresentation. They presented a specific, temporary deal as a general market condition to influence corporate management's decision, which is deceptive.
- Self-Interest over Corporate Interest: While a profit center manager's role is to optimize their division's profit, ethical management also involves transparent and honest communication, especially when decisions impact other divisions or overall corporate profitability. The manager seemingly prioritized a short-term divisional gain through a misleading claim, rather than seeking a solution that was optimal for Sky Armour Industries as a whole. This demonstrates a lack of transparency and potentially, a breach of fiduciary duty to the larger corporation.
6. Would changing the transfer price to $5.00 matter to Sky Armour Industries?
Yes, changing the transfer price to $5.00 would absolutely matter to Sky Armour Industries, and it would likely lead to further sub-optimal decisions for the company.
Here's why:
- Impact on Recycling Division's Profitability: If the transfer price for all internal transfers were set at $5.00 per pound (which is below the current full cost of $4.80 + 10% = $5.28, and even below Metalife's future price of $5.50), the Recycling Division's profitability would suffer significantly. At a full cost of $4.80, a transfer price of $5.00 only provides a $0.20 profit margin per pound, considerably less than the current $0.48 margin ($5.28 - $4.80). This could demotivate the recycling division, make them appear less profitable, and potentially lead to decisions to reduce production or seek external sales that might not be in the company's best interest.
- Distorted Performance Measurement: Setting the internal transfer price artificially low would distort the true economic contribution of the Recycling Division to the company. It would understate the value created by the internal supply.
- Inefficient Resource Allocation: If the recycling division is forced to sell at $5.00, it might discourage investment in capacity expansion or efficiency improvements, even if these would benefit the overall company, because the perceived internal profit margin is too low.
- Continuing Goal Incongruence (if the fabrication division still sees external options): While the $5.00 price might initially align the fabrication division to buy internally (as it matches the "one-time" Metalife offer), it doesn't solve the underlying issue of optimal pricing when there is excess capacity. If Metalife's future price is $5.50, and the internal transfer price is $5.00, the fabrication division would continue to buy internally. However, this is based on a misrepresentation of market price and punishes the internal supplier.
Instead of arbitrarily changing the transfer price to $5.00 based on a misleading external offer, Sky Armour Industries should revisit its transfer pricing policy. A more appropriate approach, especially with excess capacity, would be to use a variable cost plus negotiated price or a cost-plus mark-up on variable cost for internal transfers when the supplying division has excess capacity and no opportunity cost. For example, a transfer price of $3.30 (variable cost) plus a small markup, or a negotiated price between $3.30 and $5.00, would better align divisional incentives with corporate goals when excess capacity exists.