QUESTION 3

Regina Ltd. manufactures a wide range of specialized electrical products. The company is structured along divisional lines.

"Division A" manufactures a specialized motor. Monthly production is 30,000 units and the marginal cost of production is $140 per unit. Half of all output is sold to external customers at a price of $200 per unit. The remaining output is sold within

Regina Ltd. to "Division B". In accordance with the company's rules, these internal transfers are made at the same price per unit as sales to external customers (i.e $200).

"Division B" uses the motor as a component in the manufacture of an industrial heater, which is sold to external customers at a price of $350 per unit. (One motor is required for each heater). "Division B" incurs a marginal cost of $100 per unit, in addition to the transfer price paid for the motor.

A potential new customer (Quebec Ltd.) has offered to purchase 7,500 units per month of the industrial heater from "Division B" at a special contract price of $275 each. "Division B" has sufficient spare production capacity to produce these additional heaters.

YOU ARE REQUIRED TO:

(a)Assume that "Division A" has sufficient spare production capacity to enable it to produce the additional motors required by "Division B" to enable it to fulfil the Quebec Ltd. contract.

In these circumstances, explain:

Whether it would be in the best interests of Regina Ltd. to accept the Quebec Ltd. contract, and

Whether the existing transfer pricing arrangements motivate the division managers to take the decisions which are in the best interests of Regina Ltd.

as a whole. (9 marks)

(b)Now assume that "Division A" has no spare production capacity. If "Division A" were to produce the additional motors required by "Division B" to enable it to fulfil the Quebec Ltd. contract, then "Division A" would reduce its sales of motors to external customers.

Explain how your answer to part (a) would differ in these circumstances.(9 marks)

(c)Critically evaluate the transfer pricing arrangements in Regina Ltd., using your answers to parts (a) and (b) to illustrate your answer.(7 marks)

[Total: 25 marks]