QUESTION TWO [25] Tap Co. is a company specializing in the manufacture and sale of Taps. Each Tap consists of a main unit plus a set of Tap fittings. The company is split into two divisions, A and B. Division A manufactures the tap and Division B manufactures sets of tap fittings, Currently, all of Division As sales are made externally. Division B, however, sells to Division A as well as to external customers. Both of the divisions are profit centres. The following data are available for both divisions:

Division A Current selling price for each Tap R450 Costs per Tap: Fittings from Division B R75 Other materials from external suppliers R200 Labour costs R45 Annual fixed overheads R7 440 000 Annual production and sales of Taps (units) 80 000 Maximum annual market demand for Taps (units) 80 000 Division B Current external selling price per set of fittings R80 Current price for sales to Division A R75 Costs per set of fittings: Materials R5 Labour costs R15 Annual fixed overheads R4 400 000 Maximum annual production and sales of sets of fittings (units) 200 000 (including internal and external sales) Maximum annual external demand for sets of fittings (units) 180 000 Maximum annual internal demand for sets of fittings (units) 80 000 The transfer price charged by Division B to Division A was negotiated some years ago between the previous divisional managers, who have now both been replaced by new managers. Head office only allows Division A to purchase its fittings from Division B, although the new manager of Division A believes that he could obtain fittings of the same quality and appearance for R65 per set, if he were given autonomy to purchase from outside the company. Division B makes no cost savings from supplying internally to Division A rather than selling externally.

Required: 2.1 Under the current transfer pricing system, prepare a profit statement showing the profit for each of the divisions and for Tap Co. as a whole. Your sales and costs figures should be split into external sales and interdivisional transfers, where appropriate. (14) 2.2 Head office is considering changing the transfer pricing policy to ensure maximization of company profits without demotivating either of the divisional managers. Division A will be given autonomy to buy from external suppliers and Division B to supply external customers in priority to supplying to Division A. Calculate the maximum profit that could be earned by Tap Co. if transfer pricing is optimized.