Suppose that a paper mill "feeds" a downstream box mill. For the downstream mill, the marginal profitability of producing boxes declines with volume. For example, the first unit of boxes increases earnings by $10, the second $9, the third $7, and so on, until the tenth unit increases profit by just $1. The cost the upstream mill incurs for producing enough paper to make one unit of boxes is $3.50
a. If the two companies are separate profit centers, and the upstream paper mill sets a single transfer price (the price the box company pays the paper mill), what price will it set, and how much money will the company make?
b. If the paper mill were forced to transfer at marginal cost, how much money would the company make?
Paper Mill
|
Price
|
Quantity
|
Revenue
|
MR
|
MC
|
Profit
|
|
10
|
1
|
10
|
|
3.5
|
|
|
9
|
2
|
18
|
|
3.5
|
|
|
8
|
3
|
24
|
|
3.5
|
|
|
7
|
4
|
28
|
|
3.5
|
|
|
6
|
5
|
30
|
|
3.5
|
|
|
5
|
6
|
30
|
|
3.5
|
|
|
4
|
7
|
28
|
|
3.5
|
|
|
3
|
8
|
24
|
|
3.5
|
|
|
2
|
9
|
18
|
|
3.5
|
|
|
1
|
10
|
10
|
|
3.5
|
|
3. Futura Furniture Products manufactures upscale office furniture for the "Office of the Future." The sales division is comprised of regionally based sales offices made up of sales representatives and regional managers. Sales representatives-who report to the regional managers-conduct direct sales efforts with customers in their regions. As part of the sales process, representatives gather information about likely future orders and convey that information back to the regional managers. Regional managers use that information to create sales forecasts, which are then used as the basis for manufacturing schedules.
Sales representatives and regional managers are both compensated on a salary plus commission (percentage of revenue as pricing is centrally controlled). However, a regional manager's commission is adjusted based on regional sales that exceed the forecasted budget.
Corporate managers are concerned with one of Futura's key products, the "DeskPod." They worry that DeskPod forecasts are inaccurate, causing extreme havoc in the manufacturing process. How are the forecasts likely to be inaccurate? What do you think is driving this inaccuracy? How might this problem be solved?