Maxim is a large electrical equipment supplier with retail stores throughout the major towns in Jamaica. Many of the products it sells are bought in from outside suppliers, but some are currently manufactured by Maxims own manufacturing division, Electro Ltd.

The prices (a transfer price) that Electro Ltd charges to the retail stores are set by head office and have been the subject of some discussion. The current policy is for Electro Ltd to calculate the total variable cost of production and delivery and add 25% for profit. Electro argues that all costs should be taken into consideration, offering to reduce the mark-up on cost to 8% in this case. The retail stores are unhappy with the current pricing policy arguing that it results in prices that are often higher than comparable products available on the market.

Electro Ltd has provided the following information to enable a price comparison to be made of the two possible pricing policies for one of its products.

Circuit breakers

PVC: the circuit breakers have 1.5 kg of high-quality PVC in the final product. The manufacturing process loses 2% of all the PVC put in. PVC costs $2.50 per kg

Other materials: other materials are bought in and have a list price of $4.5 per kg although Maxim secures a 10% volume discount on all purchases. The circuit breakers require 0.2kg of these materials.

The labour time to produce circuit breakers is 0.50 hours per unit and labour costs $15 per hour.

Variable overheads are absorbed at a rate of 100% of labour rates and fixed overheads are 90% of the variable overheads.

Delivery is made by an outsourced distributor that charges Electro Ltd $0.60 per circuit breaker for delivery.

Required

(a) Calculate the price that Electro Ltd would charge for the circuit breakers under the existing policy of variable cost plus 25%.

(b) Calculate the increase or decrease in prices if the policy switched to total cost plus 10%.

(c) Discuss whether including fixed costs in a transfer price is a sensible policy.

(d) Discuss whether the retail stores should be allowed to buy in from outside suppliers if the prices are cheaper than those charged by Electro Ltd.