Question

Materials used by Square Yard Products Inc. in producing Division 3's product are currently purchased from outside suppliers at a cost of $5.00 per unit. However, the same materials are available with Division 6. Division 6 has unused capacity of 40,000 units and can produce the materials needed by Division 3 with the following costs per unit:

Direct materials                      $1.25

Direct labor                             $0.90

Variable overhead                  $0.85

Fixed overhead                       $0.60

1. What is the minimum transfer price per unit?  Which division will set the minimum transfer price?
2. What is the maximum transfer price per unit?  Which division will set the maximum transfer price?
3. Suppose the two divisions negotiate a transfer price of $3.75 per unit for 40,000 units. By how much will each division's income increase or decrease as a result of this transfer?

Division 3 increase or decrease?  How much?

Division 6 increase or decrease?  How much?

Answer 1

1.Minimum transfer price per unit:

The minimum transfer price will be the variable cost to division 6 is the following;

                Direct material                 =             $1.25

                Direct Labor =             $0.90

                Variable Overhead =             $0.85

                Total variable Overhead   =             $3.00

So, minimum transfer price will charge by Division 6 to Division 3 is $3.00 per unit.

Minimum transfer price will set by Division 6. Because, Division 6 is receiving position.

2. Maximum Transfer price per unit:

Maximum transfer price will be the price at which Division 3 get's from outside market i.e. $5.00 per unit.

Maximum transfer price will set by Division 3. Because, Division 3 is paying position.

3. Income position when transfer price fixed at $3.75 per unit:

Income position to Division 3:

Price from outside market           =             $5.00

Negotiate transfer price    =             $3.75

Profit from transfer pricing =             $1.25

So, Income will increase by $50,000.00 (40,000 units * $1.25)

Income position to Division 6:

Negotiate transfer price   =             $5.00

Total variable cost per unit =             $3.00

Profit from transfer pricing =             $2.00

So, Contribution Income of Division 6 will increase by $80,000.00 (40,000 units * $2.00)

Note: Fixed cost any way will incur if production start or not.