Case Information
Sky Armor Industries is a well-known producer of premium aluminum luggage, specializing in using recycled metal in their creations. Metal recycling and luggage manufacturing are the two separate segments that the business runs. Both divisions run separately and are free to conduct business with outside parties. The fabrication division does not currently purchase materials from other vendors; instead, the recycling division only supplies aluminum to that division.
Aluminum is transferred from the recycling division to the fabrication division at a cost that is 110 percent of the entire cost. Recyclable aluminum is purchased by the recycling division for $0.50 per pound. Additionally, fixed expenses are $1.50 per pound based on a monthly output of 50,000 pounds, while variable costs come to $2.80 per pound. Fifty thousand pounds of aluminum were moved between the divisions in the previous month, and the recycling division has a 70,000-pound output capacity.
Calculation of the Transfer Price
Based on the cost structure of the metal recycling division, it is possible to determine the transfer price per pound of recycled aluminum for the most recent month. The recycling section pays $0.50 per pound for recycled aluminum. At a monthly output level of 50,000 pounds, the division also has variable costs of $2.80 per pound and fixed expenses of $1.50 per pound. One adds the variable and fixed costs to get the total cost per pound:
- Variable costs per pound: $2.80
- Fixed costs per pound: $1.50
- Total cost per pound: $2.80 + $1.50 = $4.30
The aluminum transfer price is 110% of the full cost. Therefore, the price assigned per pound of recycled aluminum in the latest month would be:
- Transfer price per pound = $4.30 * 110% = $4.73
In order to cover the additional variable and fixed expenses paid by the recycling division, the transfer price is greater than the direct cost (buy price) of $0.50 per pound. The transfer price, which reflects the internal transaction between the luggage manufacturing and metal recycling divisions, aims to fairly allocate expenses while maintaining both divisions’ profitability.
Evaluating the Fabrication Manager’s Decision to Purchase 10,000 Pounds from Metalife”
The choice of whether the fabrication manager would opt to acquire 10,000 pounds of recycled aluminum from Metalife hinges on the cost implications and the possible influence on profitability, assuming that each division is thought of as a profit center (Datar & Rajan, 2020). The metal recycling section now sells aluminum to the fabrication division for a transfer price of $4.73 per pound.
However, Metalife Corporation has offered to sell the fabrication division 10,000 pounds of recycled aluminum for $5 per pound. The cost would be cheaper than the internal transfer price if the fabrication manager buys from Metalife. The price for buying aluminum from Metalife is:
10,000 pounds * $5.00 per pound = $50,000
However, there are still other factors that should be assessed. First, only 50,000 pounds of the 70,000 pounds that the metal recycling section has available for internal transfers. The capacity of the recycling division would not be utilized if external purchases were made. The opportunity expense incurred by leaving the recycling division’s available capacity unused must be taken into account (Datar & Rajan, 2020). The remaining 20,000 pounds might be sold to other parties by the recycling division. This is how much the unused capacity costs:
20,000 pounds * $4.73 per pound = $94,600
The fabrication division would not benefit financially from acquiring 10,000 pounds from Metalife as compared to the potential cost of underutilizing the recycling division’s capacity ($94,600), which is $50,000. Therefore, the fabrication manager would decide not to buy the aluminum from Metalife and instead rely on the internal transfer from the recycling division in order to maximize profitability as a profit center. The fabrication division’s expenditures would be kept to a minimum, and resources would be used as effectively as possible.
Analyzing the Purchase Decision
One must look at the entire cost effect and possible profitability to decide whether buying 10,000 pounds of recycled aluminum from Metalife is in the best interest of Sky Armour Industries. Ten thousand pounds of aluminum at a price of $5 per pound would cost Metalife $50,000. The potential cost of not using the recycling division’s remaining capacity, which may be sold externally, must also be taken into account. The following is the underutilized capacity’s potential cost:
20,000 pounds * $4.73 per pound = $94,600
The fabrication section would spend $50,000 if it made a purchase from Metalife. The price would be 10,000 pounds * $4.73 per pound, which is equal to $47,300 if the recycling division’s internal transfer were used. The cost of acquiring from Metalife ($50,000) would be greater than the cost of internal transfer ($47,300), as can be shown by comparing the two costs. Therefore, it is not in Sky Armour Industries’ best interest to buy 10,000 pounds from Metalife from a financial standpoint. This would result in more significant costs and a wasted chance of using the recycling division’s remaining capacity.
Goal Incongruence: Investigating the Root Cause
The discrepancy between the internal transfer price and the market price for recycled aluminum is what significantly contributes to the objective incongruence in this situation. This mismatch is caused by a number of variables, which causes the baggage manufacturing and metal recycling divisions to have competing interests.
Decentralized Structure
The business is run by decentralized sections that are regarded as profit centers. Each division is in charge of ensuring its own productivity and profitability (Datar & Rajan, 2020). Although this decentralized structure gives divisions the freedom to make their own decisions, it may also lead to conflicts of interest when setting prices and allocating resources.
Lack of Market-Based Pricing
The internal transfer price for the recycling division is fixed at 110 percent of the total cost of production. This cost-based pricing strategy may or may not align with the current market conditions and the actual worth of aluminum on the open market. As a result, the transfer price may produce inefficiencies since it does not accurately represent the state of the market.
Lack of Options for External Vendors
At the moment, the fabrication division does not buy materials from any external vendors. The fabrication division’s capacity to analyze costs and strike better agreements is constrained by the absence of external choices (Flayyih et al., 2020). Additionally, it limits market competition within the organization, aggravating the objective inconsistency.
Underutilization of Capacity
The recycling division works below its maximum potential. Only 50,000 pounds of metal are being moved inside despite the division’s 70,000-pound capability. Due to the underutilization of capacity, the recycling division incurs opportunity costs and experiences inefficient resource allocation. The division can consider selling the remaining capacity to third parties in order to increase income.
Information Asymmetry
According to the manager of the fabrication division, the market price for recycled aluminum is $5 per pound. The recycling division manager, however, has doubts and mistrust about this pricing (Walz & Guenther, 2021). Goal incongruence is made more difficult by the absence of clear and reliable information on the actual market pricing.
References
Datar, S. M., & Rajan, M. V. (2020). Horngren’s cost accounting: A managerial emphasis (17th ed.). Pearson.
Flayyih, H. H., Mohammed, Y. N., Talab, H. R., & Radhi, N. R. (2020). Integration of the system of Activity Based Costing and liability accounting. Integration, 1(2), 1-9.
Walz, M., & Guenther, E. (2021). What effects does material flow cost accounting have for companies? Evidence from a case studies analysis. Journal of Industrial Ecology, 25(3), 593-613. Web.