Chapter 17: Divisional Performance Evaluation
THE COPPER BOX COMPANY
Discussion Question Answers:
A basic principle in economics says that to maximize the value of the firm, a monopoly price
should be charged only once whereas all other transfers are charged at marginal cost. Transfer
pricing theory implies that the profit-maximizing solution in the Copper Box Company is to set
the price for the patented copper boxes to external customers at the price where the firm’s
However, if the transfer price is marginal cost (and assuming marginal cost is less than or equal
to average cost), Manufacturing reports no profit.1 If Manufacturing tires to report a profit by
charging Distribution a transfer price above marginal cost, firm profits are lower than in the
original case. For, if Manufacturing is able to set the transfer price above marginal cost, then
The transfer pricing rule thus holds that when two divisions inside the same firm have “market
power” (that is, they are able to charge prices above long-run marginal cost), both divisions
should not be allowed to charge prices above their own marginal costs. When there are such
HITEK BIKES
Discussion Question Answers:
1. To determine the firm’s profit maximizing price-quantity relation, derive the marginal revenue
curve from the demand curve:
1 Even if marginal cost exceeds average cost, manufacturing will still want to charge to high a price.
Q = 300
2. Substitute the profit maximizing quantity of 300 into the demand curve to find the
profit-maximizing price:
3. Since the manufacturing division sets the transfer price, it will choose the transfer price, T,
division is given by the equation,
The manufacturing division now maximizes profit
To maximize profits, take the derivative of the preceding equation, set it equal to zero, and solve
for Q.
Note that the combined profits of $765,061 are less than the profit of $990,000 in3a.
4. The optimal transfer price is the MC at the optimal output of 300 bike frames:
CELTEX
Discussion Question Answers:
1. Cash flows:
Per Gal.
If Wally ends up buying from Meas, the net cash flow of Celtex is lower by $.45 for every gallon
2. While it seems obvious that Diana Philapados should somehow intervene and prevent this
loss from occurring, the old maxim, “If it ain’t broke, don’t fix it” should be applied.
Celtex has been a successful chemical company. Its decentralized, senior management hands-off
policy seems to be working. If Diana intervenes in the current dispute, she will be asked to
The question is, are the cash flows forgone if Wally buys from Meas larger than the cash flows
from weakening the high degree of decentralization? The current Synchem-Consumer Products
The real issue here is not the transfer-pricing question and forcing or not forcing Leo to lower his
bid, but rather Leo’s competence as a manager. Either Leo knows what he is doing by bidding
$3.20 or he doesn’t. Maybe he doesn’t want the business at anything less than $3.20 because he