Advanced: Computation of divisional profits using market based transfer prices and a discussion of market based transfer prices where market imperfections exist L ltd and M Ltd are subsidiaries of the same group of companies.

L ltd produces a branded product sold in drums at a price of

£20 per drum.

Its direct product costs per drum are:

- Raw material from M Ltd: At a transfer price of £9 for 25 litres.

-Other products and services from outside the group: At a cost of£3.

L Ltd s fixed costs are £40000 per month. These costs include process labour whose costs will not alter until L ltd's output reaches twice its present level.

A market research study has indicated that L Ltd's market could increase by 80% in volume if it were to reduce its price by 20%.

M ltd produces a fairly basic product which can be converted into a wide range of end products. It sells one third of its output to lltd and the remainder to customers outside the group.

M ltd's production capacity is 1000 kilolitres per month, but competition is keeo and it budgets to sell no more than 750 kilolitres per month for the year ending 31 December 1990.

Its variable costs are £200 per kilolitre and its fixed costs are

£60 000 per month.

The current policy of the group is to use market prices, where known, as the transfer price between its subsidiaries. This is the basis of the transfer price between M Ltd and L ltd.

You are required

(a) to calculate the monthly profit position for each of L Ltd and M ltd if the sales of L ltd are

(i) at their present level, and

(ii) at the higher potential level indicated by the market research, subject to a cut in price of 20%; (10 marks)

(b) (i) to explain why the use of a market price as the transfer price produces difficulties under the conditions outlined in

(a) (ii) above; (3 marks)

(ii) to explain briefly, as chief accountant of the group, what factors you would consider in arriving at a proposal to overcome these difficulties; (7 marks)

(c) to recommend, with supporting calculations, what transfer prices you would propose.