Question 1

Manuco Ltd has been offered supplies of special ingredient Z at a transfer price of $15

per kg by Hepco Ltd which is part of the same group of companies. Helpco Ltd processes

and sells special ingredient Z to customers external to the group at $15 per kg. Helpco

Ltd bases its transfer price on cost plus 25 per cent profit mark-up. Total cost has been

estimated as 75 per cent variable and 25 per cent fixed.

Required:

Discuss the transfer prices at which Helpco Ltd should offer to transfer special ingredient

Z to Manuco Ltd in order that group profit maximizing decisions may be taken on

financial grounds in each of the following situations:

(i) Helpco Ltd has an external market for all of its production of special ingredient Z

at a selling price of $15 per kg. Internal transfer to Manuco Ltd would enable

$1.50 per kg of variable packing cost to be avoided.

(ii) Conditions as per (i) but Helpco Ltd has production capacity for 3000kg of

special ingredient Z for which no external market is available.

(iii) Conditions are as per (ii) but Helpco Ltd has an alternative use for some of its

spare production capacity. This alternative use is equivalent to 2000kg of special

ingredient Z and would earn a contribution of $6000.

Question 2

Division A of a large divisionalized organization manufactures a single standardized

product. Some of the output is sold externally whilst the remainder is transferred to

Division B where it is a sub-assembly in the manufacture of that division's product. The

unit costs of Division A's product are as follows:

$

Direct material - 4

Direct labour - 2

Direct expense - 2

Variable manufacturing overheads - 2

Fixed manufacturing overheads - 4

Selling and packing expense - variable - 1

Annually 10,000 units of the product are sold externally at the standard price of $30.

In addition to the external sales, 5000 units are transferred annually to Division B

at an external transfer charge of $29 per unit. This transfer price is obtained by deducting

variable selling and packing expense from the external price since this expense is not

incurred for internal transfers.

Division B incorporates the transferred-in goods into a more advanced product.

The unit costs of this product are as follows:

$

Transferred-in item (from Division A) - 29

Direct material and components - 23

Direct labour - 3

Variable overheads - 12

Fixed overheads - 12

Selling and packing expense - variable - 1

Division B's manager disagrees with the basis used to set the transfer price. He argues

that the transfers should be made at variable cost plus an agreed (minimal) mark-up since

he claims that his division is taking output that Division A would be unable to sell at the

price of $30.

Partly because of this disagreement, a study of the relationship between selling

price an demand has recently been made for each division by the company's sales

director. The resulting report contains the following table:

Customer demand at various selling prices:

Division A

Selling Price $20 / $30 / $40

Demand 15,000 / 10,000 / 5,000

Division B

Selling Price $80 / $90 / $100

Demand 7,200 / 5,000 / 2,800

The manager of Division B claims that this study supports his case. He suggests that a

transfer price of $12 would give Division A a reasonable contribution to its fixed

overheads while allowing Division B to earn a reasonable profit. He also believes that it

would lead to an increase of output and an improvement in the overall level of company

profits.

You are required:

(a) to calculate the effect that the transfer pricing system has had on the company's

profits, and

(b) to establish the likely effect on profits of adopting the suggestion by the manager

of Division B of a transfer price of $12.