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?
Fabrication Manager’s Decision
Assuming each division is a profit center, the fabrication manager would choose to purchase the 10,000 pounds of recycled aluminum from Metalife.
Cost per pound from Recycling Division: $5.28
Cost per pound from Metalife: $5.00
Savings per pound: $5.28 - $5.00 = $0.28
Total Savings: $0.28 × 10,000 pounds = $2,800
The fabrication manager's decision is driven by the immediate cost savings, which directly increases their division's profit.
Best Interest of Sky Armour Industries
The purchase from Metalife is not in the best interest of Sky Armour Industries as a whole. This is a classic example of goal incongruence, where a decision that benefits a division is detrimental to the overall organization.
Recycling Division's Perspective: The recycling division has an excess capacity of 20,000 pounds (70,000 pounds capacity - 50,000 pounds current production). The variable cost to produce an additional 10,000 pounds is only the purchase cost and other variable costs.
Variable Cost per pound: $0.50 (purchase) + $2.80 (other variable) = $3.30 per pound
Total Variable Cost for 10,000 pounds: $3.30 × 10,000 = $33,000
The fixed costs of $1.50 per pound are irrelevant to this decision since they are already sunk costs at the 50,000-pound production level.
Sky Armour Industries' Perspective:
Cost to buy from Metalife: $5.00 per pound × 10,000 pounds = $50,000
Cost to produce internally: $3.30 per pound × 10,000 pounds = $33,000
Loss to the company: $50,000 (external cost) - $33,000 (internal cost) = $17,000
By purchasing from an outside supplier, the company as a whole incurs an additional $17,000 in costs. The company would be better off by having its own recycling division produce the required 10,000 pounds, as this would be a more efficient use of its existing capacity.
The cause of this goal incongruence is the transfer pricing policy. The transfer price of $5.28 per pound is higher than the external market price of $5.00, creating an incentive for the fabrication division to buy externally. However, this transfer price is also significantly higher than the internal variable cost of production ($3.30 per pound), which is the relevant cost to the company as a whole. The manager of the fabrication division, evaluated on their own profit, makes a rational decision for their profit center, but not for the corporation.
Sample Answer
Transfer Price Calculation
To find the transfer price, we first need to calculate the full cost per pound of recycled aluminum.
Purchase Cost: $0.50 per pound
Other Variable Costs: $2.80 per pound
Fixed Costs: $1.50 per pound
Full Cost: $0.50 + $2.80 + $1.50 = $4.80 per pound
The transfer price is set at 110% of the full cost.
Transfer Price: $4.80 × 1.10 = $5.28 per pound