Question 7

XYZ Ltd which has a system of assessment of Divisional Performance on the basis of residual income has two Division, Alfa and Beta. Alfa has annual capacity to manufacture 15,000,000 numbers of a special component that it sells to outside customers, but has idle capacity. The budgeted residual income of Beta is GHS12,000,000 while that of Alfa is GHS10,000,000. Other relevant details extracted from the budget of Alfa for the current years were as follows.

Sale (outside customers) 12,000,000 units @ GHS180 per unit

Variable cost per unit GHS160

Divisional fixed cost GHS80,000,000

Capital employed GHS75,000,000

Cost of capital 12%

Beta has just received a special order for which it requires components similar to the ones made by Alfa. Fully aware of the idle capacity of Alfa, Beta has asked Alfa to quote for manufacture and supply of 300,000 numbers of the components with a slight modification during final processing. Alfa and Beta agree that this will involve an extra variable cost of GHS5 per unit.

You are required to calculate,

1. Calculate the transfer price which Alfa should quote to Beta to achieve its budgeted residual income.
2. Indicate the circumstances in which the proposed transfer price may result in a sub optimal decision for the company as a whole.