Problem - Lorax Electric Company manufactures a large variety of systems and individual components for the electronics industry. The firm is organized into several divisions with division managers given the authority to make virtually all operating decisions. Management control over divisional operations is maintained by an incentive system based on divisional profit and return on investment measures which are reviewed regularly by top management. Top management of Lorax has been quite pleased with the effectiveness of the system it has been using and believes that the system is responsible for the company's improved profitability over the last few years.

The Devices Division manufactures solid-state devices and is operating at capacity.  The Systems Division has asked the Devices Division to supply a large quantity of integrated circuit IC378. The Devices Division currently is selling this component to its regular customers at $0.40 each.

The Systems Division, which is operating at about 60 percent capacity, wants this particular component for a digital clock system. It has an opportunity to supply large quantities of these digital clock systems to Centonic Electric, a major producer of clock radios and other popular electronic home entertainment equipment. This is the first opportunity any of the Lorax divisions has had to do business with Centonic Electric. Centonic Electric has offered to pay $7.50 per clock system.

The Systems Division prepared an analysis of the probable costs to produce the clock systems. The amount that could be paid to the Devices Division for the integrated circuits was determined by working backward from the selling price. The cost estimates employed by the division reflected the highest per unit cost the Systems Division could incur for each cost component and still leave a sufficient margin so that the division's income statement could show reasonable improvement. The cost estimates are summarized as follows:

Proposed selling price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7.50

Costs excluding required integrated circuit (IC378):

Components purchased from outsider suppliers . . . . . . . . . . . $2.75

Circuit board etching-labor and variable overhead  . . . . . . .  0.40

Assembly, testing, and packaging-labor and variable overhead  1.35

Fixed overhead allocations. . . . . . . . . . . . . . . . . . . . . . . . . . . .  1.50

Profit margin. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .    .50  6.50

Amount which can be paid for integrated circuits

IC378 (5 x $0.20 each). . . . . . . . . . . . . . . . . . . . . . . . . . . . $1.00

As a result of this analysis, the Systems Division offered the Devices Division a price of $0.20 each for the integrated circuit. This bid was refused by the manager of the Devices Division because he felt the Systems Division should at least meet the price of $0.40 each which regular customers pay. When the Systems Division found that it could not obtain a comparable integrated circuit from outside vendors, the situation was presented to an arbitration committee which reviews such problems.

The arbitration committee prepared an analysis which showed that $0.15 would cover variable costs of producing the integrated circuit, $0.28 would cover the full cost including fixed overhead, and $0.40 would provide a gross margin equal to the average gross margin on all of the products sold by the Devices Division. Jane Thomas, the manager of the Systems Division, reacted by stating, "It could sell us that integrated circuit for $0.20 and still earn a positive contribution toward profit. In fact, it should be required to sell at its variable cost--$0.15--and not be allowed to take advantage of us."

Lou Belcher, manager of Devices, countered by arguing, "It doesn't make sense to sell to the Systems Division at $0.20 when we can get $0.40 outside on all we can produce. And we're already operating at capacity, so selling circuits to Systems means that we don't fill orders from our existing customers.  We can't risk losing our customers! In fact, Systems could pay us almost $0.60 each, and it would still have a positive contribution to profit."

The recommendation of the committee, to set the price at $0.40 per unit so that Devices could earn a "fair" gross margin, was rejected by both division managers. Consequently, the problem was brought to the attention of the vice-president of operations.

Why did each division reject the proposed $0.40 transfer price?

What is the immediate economic effect on Lorax Electric Company as a whole if the Devices Division were required to supply IC378 to the Systems Division at $0.40 per unit-the price recommended by the arbitration committee?  What are the calculations?

Would you intervene in this conflict to enforce an internal transfer, or would you let the divisional managers' decision not to proceed with the clock systems stand? What are the pros and cons of this kind of intervention?