The ZZ Group has two divisions, X and Y. Each division produces only one type of product: X produces a component, C and Y produces a finished product, FP. Each FP needs one C. It is the current policy of the group for C to be transferred to Division Y at the marginal cost of £10 per component and that Y must buy all the components it needs from X. The markets for the component and the finished product are competitive and price sensitive. Component C is produced by many other companies but it is thought that the external demand for the next year could increase to 1000 units more than the sales volume shown in the current budget for Division X. Budgeted data, taken from the ZZ Group internal information system, for the divisions for the next year is as follows:

Four measures are used to evaluate the performance of the divisional managers. Based on the data above, the budgeted performance measures for the two divisions are as follows: 

Proposed policy 

ZZ Group is thinking of giving the divisional managers the freedom to set their own transfer price and to buy the components from external suppliers but there are concerns about problems that could arise by granting such autonomy. 

Required 

1. If the transfer price of the component is set by the manager of Division X at the current market price (£20 per component), recalculate the budgeted performance measures for each division. 

2. Discuss the changes to the performance measures of the divisions that would arise as a result of altering the transfer price to £20 per component. 

3. a. Explain the problems that could arise for each of the divisional managers and for ZZ Group as a whole as a result of giving full autonomy to the divisional managers. 

b. Discuss how the problems you have explained could be resolved without resorting to a policy of imposed transfer prices.

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Division X Income statement Sales £70 000 Cost of sales Variable costs £50 000 Contribution £20 000 £15 000 Fixed costs (controllable) Profit Production/Sales (units) External demand (units) £S 000 so00 (3000 of which are transferred to Division Y) 3000 (Only 2000 of which can be currently satisfied) Capacity (units) External market price per unit 5000 £20 Balance sheet extract Capital employed £60 000 Other information Cost of capital charge 10% Division Y Income statement Sales £270 000 Cost of sales Variable costs £114 000 Contribution £156 000 Fixed costs (controllable) Profit £100 000 £56 000 Production/Sales (units) Capacity (units) Market price per unit 3000 7000 £90 Balance sheet extract Capital employed £110 000 Other information Cost of capital charge 10%