# Applying Optimal Transfer Pricing Rule

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Problem 1: Megatron Inc. (Applying Optimal Transfer Pricing Rule) Megatron Inc. has two divisions: a laptops division that manufactures gaming laptops and an electronics division that produces two types of graphic cards – Sapphire and Force. The Sapphire graphic cards can be used in the gaming laptops produced by the laptops division as well as sold externally whereas the Force graphic cards are sold exclusively on the external market. Following is data on the price, costs and hours required for each graphics card: Sapphire Force Selling Price per card \$400 \$150 Variable Cost per card 100 60 Hours/card 0.6 0.2

The electronics division has a production capacity of 27,000 hours. The external market demand for Sapphire cards is 25,000 and the external market demand for Force cards is 45,000.

1. a) Determine the transfer pricing schedule for the internal transfer of Sapphire cards that conforms to the optimal transfer pricing rule (3 points)
2. b) Determine the total charge for internally shipping 25,000 Sapphire cards (2 points) Problem 2: Big Tommy Motors (Issues with implementing Optimal Transfer Pricing Rule) The engines division of Big Tommy Motors produces engines for external sale as well as for internal use by the Cars division. The engines division has 20,000 hours of production capacity. Following is information on cost and price for an engine: Selling Price per engine \$4,000 Variable Cost per engine 2,000 Market Demand 15,000 Internal Demand 5,000 Hours/engine to produce 1

The monthly fixed cost of the engines division is currently \$7,500,000. One of the parts of the engine is a valve train that is currently manufactured in-house. The variable cost of producing a valve train is \$400 (note that this \$400 is included in the \$2,000 variable cost of the engine). One of the suppliers to the engine division has offered to produce the valve trains for \$490 per valve train. If the production of valve trains is outsourced, the manager believes she can also bring down monthly fixed costs of the division from \$7,500,000 to \$6,000,000.

1. a) Would Big Tommy Motors prefer the outsourcing of valve train production by the engines division (i.e. compute the effect of outsourcing on the total monthly cost of producing 20,000 engines)? (2 points)
2. b) If Big Tommy Motors uses the optimal transfer pricing rule for internal transfer of engines, will the manager of the engines division prefer to outsource the production of valve trains (i.e. compute the effect of outsourcing on the total monthly profits of the engines division)? (3 points)