Yu plc (Mercury) manufactures and sells handbags. Mercury has two divisions which are located in different countries, Geeland and Teeland. Teeland is a more economically developed country and goods will normally sell for a higher price in Teeland.

Division A (Geeland) manufactures the handbags. This division sells the bags to Division B (Teeland) and also to external customers.

Division B (Teeland) undertakes some additional manufacture to the handbags (stitching of the name of specific brands, for example) and sells the handbags to external customers.

The budgeted information for the next financial year is as follows:

Division A (Geeland)

Anticipated external demand for handbags    110,000 handbags

Demand from Division B for handbags           255,000 handbags

Average external market selling price per handbag             $89.00

Variable costs                                                       $61.00 per handbag

Annual fixed costs                                                       $2,000,000

Division B (Teeland)

Sales of handbags to external customers                       255,000 handbags

Average external market selling price per handbag              $97.00

Division A transfers goods to division B on the basis of variable cost. The cost of processing and manufacture for Division B is $5.00 per handbag and Division B has annual fixed costs of $ 1,500,000.

The Head Office (HO) of Yu is keen to impose fixed transfer prices upon the two divisions to avoid any arguments between the managers of the respective divisions. HO is also keen the ensure that Division A transfers the market requirement to Division B, given the higher profit that Division B can make.

Required:

1. Produce statements that show the budgeted profit for the next year for each of the two divisions. Your profit statements should show sales and costs split into external and internal transfers where appropriate.

2. Explain the behavioural issues that could arise as a result of the Head Office of Yu imposing transfer prices on the Divisions and explain how a “dual –rate pricing” system may solve this