Prem International has two large subsidiaries: Oil and Chemical. Oil is an oil-refining business, and its main product is gasoline. Chemical produces and sells a variety of chemical products.
Chemical owns a polystyrene processing plant next to Oil’s refinery. The polystyrene plant was built at the same time that Oil built a benzene plant at the refinery. Benzene is the raw material needed by Chemical to produce polystyrene. Chemical’s managers believe they can sell 50 million kg of polystyrene per year, which is less than full capacity. Following are Chemical’s expected revenues and costs for the polystyrene plant (volume is measured using weight in kilograms rather than using a liquid measure such as litres, because weight is not affected by temperature):
…………………………………………………………………….Per Kilogram
Selling price ………………………………………………………………$0.30
Costs: Benzene (to be purchased from Oil) ………………………………….$ ?
Variable production costs …………………………………………………..0.03
Fixed production costs ……………………………………………………..0.05
Oil can operate at full capacity and sell all of the gasoline it produces. Following are Oil’s expected revenues and costs for the production of gasoline:
………………………………………………………………………….Per Kilogram
Selling price ………………………………………………………………………$0.16
Costs: Crude oil …………………………………………………………………..$0.06
Variable production costs ………………………………………………………….0.02
Fixed production costs …………………………………………………………….0.07
For every kilogram of benzene that Oil produces, it will forgo selling a kilogram of gasoline. However, 50 million kilograms per year would be only a small portion of total volume at the refinery. Following are Oil’s expected revenues and costs for the production of benzene (these costs include the costs of refining the crude oil):
………………………………………………………………………….Per Kilogram
Selling price (to Chemical) ………………………………………………………..$ ?
Costs: Crude oil …………………………………………………………………$0.06
Variable production costs ………………………………………………………0.04
Fixed production costs …………………………………………………………0.09
REQUIRED
A. On a company-wide basis, should Prem International produce polystyrene this year? Why or why not?
B. Using the usual quantitative rules for short-term decisions (Chapter 4), what is the maximum price that Chemical’s managers would be willing to pay for benzene?
C. Would Chemical’s managers be willing to pay the maximum transfer price calculated in Part B? Why or why not?
D. Using the usual quantitative rules for short-term decisions (Chapter 4), what is the minimum price that Oil’s managers would be willing to receive for benzene?
E. Would Oil’s managers be willing to receive the minimum transfer price calculated in Part D? Why or why not?
F. What transfer price might be fair to the managers of both subsidiaries? Explain.
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