Question 2

In Bradford Ltd, there are two divisions: Transportation and Refining Divisions. The below is relevant information:

1. Transportation Division:

The purchase price of crude oil from fields under a long-term contract is 13 per barrel, and Transportation Division purchases crude oil in the North Sea and also transports the crude oil to London.

Other costs:

Variable costs per barrel of crude oil 2

Fixed costs per barrel of crude oil 3

Total 5

The pipeline from the North Sea to London can carry 35,000 barrels of crude oil per day.

2. Refining Division:

The external purchase price of crude oil from outside suppliers is 23 per barrel.

The Refining Division is buying 20,000 barrels a day from the outside supplier and 10,000 barrels a day from Transportation Division.

Refining Divisions other costs:

Variable costs per barrel of petrol 8

Fixed costs per barrel of petrol 4

Total 12

The refining division convert the crude oil into petrol and the conversion ratio is 1:1. The external market price to outside parties is 60 per barrel of petrol.

The Refining Division has been operating at capacity of 30,000 barrels of crude oil a day.

Required:

a) What is the cost-based transfer price at 112% of full costs? What is the sum of Transportation and Refining Divisions operating profit using the 112% of full cost transfer price? (8 marks)

b) Assume that the Refining Division buys 1,000 barrels of crude oil from the Transportation Division. The Refining Division converts these 1,000 barrels of crude oil into 500 barrels of petrol and sells them to external retailers. What is the sum of Transportation and refining Division operating profit at the negotiated transfer price of 25?

(6 marks)

c) Remember that the Refining Division of Bradford Ltd was purchasing crude oil locally for 23 a barrel. The Refining Division has located an independent producer in the North Sea who is willing to sell 20,000 barrels of crude oil per day at 17 per barrel delivered to the pipeline (Transportation Division). The Transportation Division has excess capacity and can transport the crude oil at its variable costs of 2 per barrel. Should Bradford Ltd purchase from the independent producer or local supplier? (5 marks)

d) In the context of a divisional organisation, explain the criteria an effective transfer pricing system has to satisfy. In your discussion, you also need to discuss whether or not including fixed costs in a transfer price is a sensible policy.

(6 marks)