Question

Bounce Ltd is a leading manufacturer and retailer of one type of product, ProdX. It has divided its operations into three divisions i.e.

Division A: Supply rubber

Division B: Compound rubber with chemicals to produce finished rubber

Division C: Produce ProdX

Division B has offered to buy 65,000 meters of rubber per annum from Division A at a price of £45 per meter. Although the total capacity of the Division A is 135,000 meters per annum, its normal production levels are 118,000 meters per annum. The production costs per meter (under normal production of 118,000 meters) of rubber are as follows:

Direct material: £17

Direct labour:     £13

Variable overhead: £6

Fixed overhead (i.e. total fixed overheads/118,000): £16

Total: £53

Division A has been selling its finished products i.e. rubber to outside buyers at £62 per meter. Division B has been buying rubber from outside suppliers at £59 per meter.

Required:

a) Presuming each divisional manager aims to optimize their division’s financial performance; discuss with reason(s) whether the manager of Division A will accept a purchase offer of £45 per meter. Calculate the financial implication of accepting or rejecting the offer on Division A.

b. Will the internal transfer result in the financial gain or loss for the company? Explain the reason(s) behind this gain or loss. Calculate the financial implication of the internal transfer on Bounce Ltd.

Note: For (a) and (b) above, please use numerical evidence to justify your answer.

c. If division A loses its excess capacity, show with reasons, the maximum transfer price Division B would be willing to pay and the minimum transfer price Division A would be willing to accept.

d. If Division A loses its excess capacity, will Bounce Ltd benefit from future internal transfers?

Division C of Bounce Ltd currently purchases a fixed quantity finished rubber from Division B for £76 per meter. The manager of Division B is considering the prospects of raising the prices of the finished rubber from £76 to £90 per meter; a proposal which is strongly opposed by Division C. Division C is able to purchase finished rubber at £80 per meter in the open market. The cost of production per meter in the Division B is as follows:

Direct materials: £47 (Includes £44 paid to Division A + other direct materials)

Direct labour: £15

Variable overhead: £4

Fixed overhead per meter: £12

Total: £78

If Division B stopped supplying rubber to Division C, they will be able to save one-fourth of the fixed overheads per meter. Currently, Division B does not have any alternative use for its spare capacity.

Required:

1. Calculate the maximum transfer price Division C would be willing to pay and the minimum transfer price Division B would be willing to accept.
2. From the perspective of Bounce Ltd, examine whether Division C should purchase steel from Division B or if it should purchase from the open market.

Answer 1

Transfer price=Differential /varaiable cost/unit+Opportunity cost to the company as a whole ,of this internal transfer

where opportunity cost is determined as follows:

is $ 0 ,if the selling dept.has idle capacity ,ie. Working below capacity

& is the profit foregone,ie.( the difference between outside sale value less the variable cost to produce) , if operating at capacity)

a..Variable costs for A :
Direct material	17
Direct labor	13
VOH	6
Total variable costs	36

As Division A is working below capacity,

Transfer price of $ 45 is profitable for div. A

ie.Transfer price -vVariable cost /m= 45-36= $ 9 (profit for A)

Financial implication for Dept. A--- $ 9 profit /m

b. To the company as a whole
NO Sale value foregone for A(wkg. Below capacity)	0
Savings on purchase price by B(59-45)/m	14
Net advantage to company due to internal transfer	14
	Per m

c. If there is no excess capacity

Minimum transfer price Division A would be willing to accept= Variable cost+Profit foregone

ie. 36+(62-45)=

53

Maximum transfer price Division B would be willing to pay

at the outside purchase price,ie.

59

D. For the company as a whole
Sale value foregone for A(62-45)	-17
Savings on purchase price by B(59-45)/m	14
Net loss to company due to internal transfer	-3
	Per m

B&C

Maximum transfer price Division C would be willing to pay

is the Purchase price from the open market,ie.

$ 80/m

Minimum transfer price Division B would be willing to accept

Its variable cost/m+1/4 of fixed Ohs/m (as opportunity cost is 0--No alterante use for spare capacity) )

ie. (47+15+4+3)=

69

For the company as a whole
Sale value foregone for B(No use for spare capacity)	0
Savings on purchase price by B(80-76)/m	4
Savings in Fixed costs of B foregone(12*1/4)	-3
Net advantage to company due to internal transfer	1
	Per m