The Z division of XYZ Ltd., produces a component which it sells externally, and can also be transferred to other divisions within the organization. The division has set a performance target for the coming financial year of residual income of Shs. 5,000,000. The following budgeted information relating to Z division has been prepared for the coming financial year.

Maximum production/sales capacity 800,000 units.

Sales to external customers: 500,000 units at Sh.37.

Variable cost per component Sh.25.

Fixed costs directly attributable to the division Sh.1,400,000.

Capital employed: Sh.20,000,000 with cost of capital of 13%

The X division of XYZ Ltd has asked Z division to quote a transfer price for units of the component.

Required:

Calculate the transfer price per component which Z division should quote to X division so that its residual income target is achieved. (6 marks)

Explain why the transfer price calculated in (i) above may lead to sub-optimal decision making from the point of view of XYZ Ltd taken as a whole. (4 marks)