IM20.7 Advanced: Computation of three different transfer prices and the extent to which each price encourages goal congruence. English Allied Traders plc has a wide range of manufacturing activities, principally within the UK. The company operates on the divisionalized basis with each division being responsible for its own manufacturing, sales and marketing, and working capital management. Divisional chief executives are expected to achieve a target 20 per cent return on sales. A disagreement has arisen between two divisions which operate on adjacent sites. The Office Products Division (OPD) has the opportunity to manufacture a printer using a new linear motor which has recently been developed by the Electric Motor Division (EMD). Currently, there is no other source of supply for an equivalent motor in the required quantity of 30 000 units a year, although a foreign manufacturer has offered to supply up to 10000 units in the coming year at a price of 9 each. EMD's current selling price for the motor is 12. Although EMD's production line for this motor is currently operating at only 50 cent of its capacity, sales are encouraging and EMD confidently expects to sell 100 000 units in for the next year, and its maximum output of 120 000 units in the following year. EMD has offered to supply OPD's requirements for the next year a transfer equal to the normal selling price, less the variable selling and distribution costs that it would not incur on this internal order. OPD responded by offering an alternative transfer price of the standard variable manufacturing cost plus a 20 per cent profit margin. The two divisions have been unable to agree, so the corporate operations director has suggested a third transfer price equal to the standard full manufacturing cost plus 15 per cent. However, neither divisional chief executive regards such a price as fair. EMD's budget for the next year for the production and sale of motors, based on its standard costs for the forecast 100 000 units sales, but excluding the possible sales to OPD, is as follows: (000) 1200 360 230 40 Sales revenue (100 000 units at 12.00 each) Direct manufacturing costs Bought-in materials Labour Packaging Indirect manufacturing costs Variable overheads Line production managers Depreciation Capital equipment Capitalized development costs Total manufacturing costs 10 30 150 60 880 50 Sales and distribution costs Salaries of sales force 50 Carriage 20 General overhead Total costs 1000 Profit 200 Notes 1 The costs of the sales force and indirect production staff are not expected to increase up to the current production capacity. 2 General overhead includes allocations of divisional administrative expenses and corporate charges of 20 000 specifically related to this product. 3 Depreciation for all assets is charged on a straight line basis using a five-year life and no residual value. 4 Carriage is provided by an outside contractor. Required: (a) Calculate each of the three proposed transfer prices and comment on how each might affect the willingness of EMD's chief executive to engage in inter divisional trade. (10 marks) (b) Outline an alternative method of setting transfer prices that you consider to be appropriate for this situation, and explain why it is an improvement on the other proposals. (5 marks) ICAEW P2 Management Accounting and Financial Management 2
