Question 2 Transfer Pricing

Lovisa manufactures a range of watches. As part of the production process, the watch band department supplies watch bands to the assembly department. The cost to produce each watch band is outlined below:

Direct materials	$1.50
Direct labour	$0.75
Variable overhead	$0.80
Fixed overheard	$0.40

There is an external market for watch bands and the current market price is $5.50.

Required:

1. Provide and discuss an example (include financial figures and workings) which illustrates how using cost-plus pricing for the transfer price of watch bands could result in issues of goal congruence.
2. Provide and discuss three examples (include financial figures and workings) which illustrate how transfer prices for watch bands could be set using the general transfer price rule and could vary depending on the watch band department's capacity.