Question

Gatco Industries is a decentralized firm. It has two production centres: Vancouver and Kamloops. Each one is evaluated based on its return on investment. Vancouver has the capacity to manufacture 100,000 units of component TR222. Vancouver's variable costs are $150 per unit. Kamloops uses component TR222 in one of its products. Kamloops adds $90 of variable costs to the component and sells the final product for $450.
Requirements Consider the following independent situations:
(a) Vancouver can sell all 100,000 units of TR222 on the open market at a price of $250 per unit. Kamloops is willing to buy 10,000 of those units. What should the transfer price be? Explain your decision. (b) Of the 100,000 units of component TR222 it can produce, Vancouver can sell 70,000 units on the open market at a price of $250 per unit. Kamloops is willing to buy an additional 10,000 units. What should the transfer price be? Explain your decision. (c) Of the 100,000 units of component TR222 it can produce, Vancouver can sell 80,000 units on the open market at a price of $250 per unit. Kamloops is willing to buy an additional 30,000 units. What should the transfer price be? Explain your decision. (d) The head office of West-Coast has asked the two centres to negotiate a transfer price. List the advantages and disadvantages of negotiated transfer prices. (adapted from CGA-Canada, now CPA Canada)

Answer 1

(a) Vancouver can sell all 100,000 units of TR222 on the open market at a price of $250 per unit. Kamloops is willing to buy 10,000 of those units. What should the transfer price be? Explain your decision.

Ans Since there is no excess capacity and Vancouver will lose $100(250-150) per unit contribution margin by selling it to Kamloops so Transfer price should be:

Variable cost pu + Lost CM per unit

$150+$100 = $250 per unit

(b) Of the 100,000 units of component TR222 it can produce, Vancouver can sell 70,000 units on the open market at a price of $250 per unit. Kamloops is willing to buy an additional 10,000 units. What should the transfer price be? Explain your decision.

Ans Since it has excess capacity of 30000 units and there is no lost contribution margin if sold internally to Kamloops, its Transfer price should be:

Variable cost pu + Lost CM per unit

$150 + $0 = $150

(c) Of the 100,000 units of component TR222 it can produce, Vancouver can sell 80,000 units on the open market at a price of $250 per unit. Kamloops is willing to buy an additional 30,000 units. What should the transfer price be? Explain your decision.

Ans: Since it has excess capacity for only 20000 units and Kamloops needs 30000 units so there is lost contribution of $100 per unit on 10000 units

So transfer price should be:

Variable cost pu + Lost CM per unit

$150 + (10000 x $100)/30000

$150 + $33.33 = $183.33

(d) The head office of West-Coast has asked the two centres to negotiate a transfer price. List the advantages and disadvantages of negotiated transfer prices.

Ans: Advantages of negotiated transfer price is that overall company profit increases since it doesn’t need to pay any additional beyond variable cost and profit remains in the company, secondly negotiated transfer price takes care of both division and both the division benefits by internal transfer.

Disadvantages: Sometimes there is clash of interest between the divisions since performance is evaluated based on return on investment and a transfer price below the market price undermines the ability of selling division and if there is some alternative available purchasing division prefers to purchase from open market that is cheaper than transfer price negotiated.