Transfer Pricing Team Case Due 2:00 PM, May 11

Gheen Electric Company manufactures a large variety of systems and components for the electronics
industry. The firm is organized into several divisions with divisional managers given the authority to make
virtually all operating decisions. Management control over divisional operations is maintained by a system
of divisional profit and ROI measures which top management reviews regularly. The top management of
Gheen Electric has been quite pleased with the effectiveness of the system they have been using and believe
that it is responsible for the company's improved profitability over the last few years.
The company's Circuit Division manufactures solid-state devices. The company's Systems Division has
asked the Circuit Division to supply it with 150,000 units of integrated circuit IC378. The Circuit Division
currently sells this circuit to its regular customers at a price of $4 per unit. At the $4 price, the outside
demand for the IC378 equals 400,000 units, which is just sufficient for the Circuit Division to be operating
at full capacity. (The Circuit Division estimated that outside demand for the IC378 would drop by 75,000
units, if the price were to be raised to $4.50, and that the outside demand would drop by 150,000 units, if
the price were to be raised to $5.00 per unit. Similarly, the Circuit Division has estimated that outside
demand for the IC378 would increase by 75,000 units, if the price were to be lowered to $3.50, and that the
outside demand would increase by 150,000 units, if the price were to be lowered to $3.00 per unit.)
The Systems Division, which is currently operating at only 60 percent of capacity, wants this particular
circuit for a digital clock system. It has an opportunity to supply 150,000 of these clock systems to
Centonic Products, a major producer of clock radios and other popular electronic equipment. This is the
first opportunity any of the Gheen divisions have had to do business with Centonic Products. Centonic has
offered to pay the Systems Division $11.60 per clock system.
The Systems Division has prepared an analysis of the probable costs to produce the clock system for
Centonic. The division's cost analysis is shown below:
Proposed price per system . . . . . . . . . . . . . . . . .
$11.60
Costs, excluding the required integrated circuit
(IC378) from the Circuit Division:
Components purchased from other suppliers . . . . . . . . . . .. $ 4.20
Circuit board etchingClabor and variable overhead . . . . . .. 0.50
Assembly, testing, and packingClabor and variable overhead . 0.80
Fixed overhead allocation . . . . . . . . . . . . . . . . . 3.00
Profit margin . . . . . . . . . . . . . . . . . . . .
0.60
9.10
Amount which can be paid for the integrated circuit
(IC378) from the Circuit Division . . . . . . . . . . . . .
$2.50
The $2.50 amount above that can be paid to the Circuit Division for IC378 was determined by working
backwards from the proposed selling price to Centonic. The cost estimates used by the Systems Division in
the above analysis represent the highest amounts that the Systems Division can incur for the various cost
components and still realize a small profit margin.
As a result of this analysis, the Systems Division has offered the Circuit Division a price of $2.50 for each
unit of IC378. Tom Belcher, manager of the Circuit Division, refused this bid because Tom felt that the
Systems Division should at least meet the $4 per circuit price that regular customers are currently paying.
When the Systems Division found that it could not obtain a comparable integrated circuit from outside
vendors, the situation was brought to an arbitration committee that has been set up to review such
problems.
The arbitration committee prepared an analysis that showed that a price of $1.80 per unit for IC378 would

cover the Circuit Division's variable costs of producing the circuit. A price of $2.75 per unit would
cover the division's full costs, including fixed overhead and a price of $3.50 per unit would cover all costs
plus provide a profit margin on each circuit that was equal to the average profit margin on all circuits
produced and sold by the Circuit Division.
Sue Adams, manager of the Systems Division, reacted to the committee's finding by saying, "Tom Belcher
could sell us that integrated circuit for $2.50 per unit and still earn a positive contribution toward profits.
In fact, he should be required to sell at his variable cost, $1.80 per unit, and not be allowed to take
advantage of us."
Tom Belcher countered by arguing, "It doesn't make sense to sell IC378 to the Systems Division for $2.50
per unit when we can get $4 per unit from our regular customers. In fact, the Systems Division could pay
us as much as $5.50 per unit for IC378, and they would still have a positive contribution to profit. Why
should we be forced to subsidize their inability to compete?"
The arbitration committee recommended a price of $3.50 per unit for IC378 so that the Circuit Division
could earn a "fair" profit on the business. However, both divisional managers rejected this price.
Consequently, the problem has been brought to the attention of the vice president of operations.
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Assignment:
Taking the role of the vice president of operations, write a memo to Sue Adam and Tom Belcher giving and
explaining your decision concerning this transfer pricing dispute. The body of the memo should not exceed
a single page. You may, however, attach calculations, charts or other supplemental material.
This case is to be completed as a team assignment. Your case will be graded based on the written
presentation as well as the soundness of your analysis. The maximum points to be earned on the case are
30. On May11, I will distribute a one-item questionnaire asking each student to rate the contribution of
each team member to the team case as either satisfactory or unsatisfactory. Each students grade will start
out with the team grade I determine. If two members of the team (not including the student being rated) rate
a student as unsatisfactory, that student will lose 6 points. If all three of the team members (not including
the student being rated) rate a student as unsatisfactory, the student will lose 20 points.
Although you need not specifically address the questions below, doing so may clarify your thinking with
regards to this case. Whether or not you consider these questions in your memo, you should be prepared to
discuss these questions in class on May 11.
1. What transfer price should control the sale of IC378 to the Systems Division? What computations
support your position?
2. What would be the effect on the profits of Gheen Electric as a whole if transfers were made at the $3.50
per unit price recommended by the arbitration committee? What would be the effect if transfers were made
at $5 per unit?
3. Identify the organizational and behavioral difficulties, if any, which are inherent in this situation.