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.
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.
Sky Armour Industries is a company with two distinct divisions: metal recycling and luggage fabrication, operating independently. The issue at hand revolves around the transfer pricing of recycled aluminum between these divisions. This essay aims to address the questions raised concerning the transfer price, potential purchase from an external supplier, and the ethical implications associated with these decisions.
During the most recent month, 50,000 pounds of aluminum were transferred from the recycling division to the fabrication division at 110% of full cost. To calculate the transfer price per pound of recycled aluminum:
Full Cost = Variable Costs + Fixed Costs Full Cost = ($0.50 + $2.80) + ($1.50) = $4.80 per pound
Transfer Price = 110% of Full Cost Transfer Price = 1.10 * $4.80 = $5.28 per pound
Therefore, during the most recent month, the transfer price per pound of recycled aluminum was $5.28.
The fabrication division anticipates the need for 60,000 pounds of aluminum next month, while Metalife Corporation offers 10,000 pounds of recycled aluminum at $5.00 per pound. To decide whether to purchase from Metalife, we should compare the external purchase cost with the internal transfer price.
External Purchase Cost = 10,000 pounds * $5.00 = $50,000 Internal Transfer Cost = 10,000 pounds * $5.28 = $52,800
The internal transfer cost is higher than the external purchase cost, indicating that it would be economically advantageous for the fabrication manager to choose the 10,000 pounds from Metalife.
The cause of this goal incongruence lies in the difference in the perspectives of the two divisions. The recycling division is incentivized to maximize its profitability by charging a transfer price that incorporates fixed costs. In contrast, the fabrication division seeks to minimize costs, thus preferring to purchase externally when it’s cheaper. This misalignment of goals can result in suboptimal decisions for the overall company.
The fabrication division manager’s suggestion to adopt the $5.00 per pound market price as the new transfer price raises ethical concerns. While it may be economically advantageous for the fabrication division in the short term, it’s important to consider the potential long-term impact on the recycling division and the company’s overall profitability.
The sudden price cut from Metalife to $5.00 per pound was a one-time offer due to excess inventory. Future orders would be priced at $5.50 per pound. Therefore, adopting $5.00 as the new transfer price would not be a reflection of the true market price, and it would not be in the best interest of Sky Armour Industries.
Changing the transfer price to $5.00 per pound would have a negative impact on Sky Armour Industries. It would result in a lower transfer price compared to the actual cost of production in the recycling division, potentially leading to losses in that division. This could also discourage efficient resource utilization and investment in the recycling division.
In conclusion, the transfer pricing issue at Sky Armour Industries highlights the need for aligning divisional goals with the company’s overall objectives. While external purchasing decisions may appear cost-effective in the short term, they should be evaluated carefully to ensure the long-term sustainability and profitability of the company. Additionally, ethical considerations must guide decisions, ensuring fairness and transparency in interdivisional transactions. Ultimately, a fair and reflective transfer pricing mechanism is essential for the success and ethical operation of the company.
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