Problem

The San Ramon Corporation makes water pumps. The Engine Division makes the engines and supplies them to the Assembly Division where the pumps are assembled. San Ramon is a successful and profitable corporation that attributes much of its success to its decentralized operating style. Each division manager is compensated on the basis of division operating income.

The Assembly Division currently acquires all its engines from the Engine Division. The Assembly Division manager could purchase similar engines in the market for $400.

The Engine Division is currently operating at 80% of its capacity of 4,000 units and has the following particulars:

Direct materials ($125 per unit x 3,200 units) $400,000

Direct manufacturing labor ($50 per unit x 3,200 units) 160,000

Variable manufacturing overhead costs ($25 per unit x 3,200 units) 80,000

Fixed manufacturing overhead costs 520,000

All the Engine Division's 3,200 units are currently transferred to the Assembly Division. No engines are sold to the outside market.

The Engine Division has just received an order for 2,000 units at $375 per engine that would utilize half the capacity of the plant. The order has either to be taken in full or rejected totally. The order is for a slightly different engine than what the Engine Division currently makes but takes the same amount of manufacturing time. To produce the new engine would require direct materials per unit of $100, direct manufacturing labor per unit of $40, and variable manufacturing overhead costs per unit of $25.

Required:

1. From the viewpoint of the San Ramon Corporation as a whole, should the Engine Division accept the order for the 2,000 units?

2. What range of transfer prices will result in achieving the actions determined to be optimal in requirement l, if division managers act in a decentralized manner? Use the transfer pricing rule.

3. The manager of the Assembly Division has proposed a transfer price for the engines equal to the full cost of the engines including an allocation of overhead costs. The Engine Division allocates overhead costs to engines on the basis of the total capacity of the plant used to manufacture the engines.

a. Calculate the transfer price for the engines transferred to the Assembly Division under this arrangement.

b. Do you think that the transfer price calculated in requirement 3a will result in achieving the actions determined to be optimal in requirement l, if division managers act in a decentralized manner?

Comment in general on one advantage and one disadvantage of using full costs of the producing division as the basis for setting transfer prices.