Question

Process Co has two divisions, A and B. Division A produces three types of chemicals: products L, M and S, using a common process. Each of the products can either be sold by Division A to the external market at split-off point (after the common process is complete) or can be transferred to Division B for individual further processing into products LX, MX and SX.

In November 20X1, which is a typical month, Division A’s output was as follows:

Product             Kg

     L               1,200

     M              1,400

     S               1,800

The market selling prices per kg for the products, both at split-off point and after further processing, are as follows:

                         $                            $

     L               5.60        LX            6.70

     M              6.50        MX           7.90

     S               6.10        SX           6.80

The specific costs for each of the individual further processes are:

Variable cost of $0.50 per kg of LX

Variable cost of $0.70 per kg of MX

Variable cost of $0.80 per kg of SX

Further processing leads to a normal loss of 5% at the beginning of the process for each of the products being processed.

Required

1. Calculate and conclude whether any of the products should be further processed in Division B in order to optimise the profit for the company as a whole.

It has been suggested that Division A should transfer products L and M to Division B for further processing, in order to optimise the profit of the company as a whole. Divisions A and B are both investment centres and all transfers from Division A to Division B would be made using the actual marginal cost. As a result, if Division A were to make the transfers as suggested, their divisional profits would be much lower than if it were to sell both products externally at split-off point. Division B’s profits, however, would be much higher.

Required

       (b) Discuss the issues arising from this suggested approach to transfer pricing.

Answer 1

Impact on revenue of the company as a whole due to further processing and deciding the products to be further processed.

Division A

Particulars	Product L	Product M	Product S
Units produced Division A	1200	1400	1800
Selling price per unit	$5.60	$6.50	$6.10
Total Revenue To division A	$6,720.00	$9,100.00	$10,980.00

Division B

Particulars	Product LX	Product MX	Product SX
Units transferred by Division A	1200	1400	1800
Less: -Normal loss (5%)	-60	-70	-90
Units produced by division B	1140	1330	1710
Incremental Revenue per unit
Selling Price Division B	$6.70	$7.90	$6.80
Less: - Variable cost of further processing	-$0.50	-$0.70	-$0.80
Incremental Revenue per unit	$6.20	$7.20	$6.00
Units produced by division B	1140	1330	1710
Incremental Revenue after further processing	$7,068.00	$9,576.00	$10,260.00
Net Increase/(Decrease) in revenue due to further processing	$348.00	$476.00	($720.00)

It has been suggested that Division A should transfer products L and M to Division B for further processing, in order to optimize the profit of the company as a whole.Revenue due to further processing increases in product L and M but further processing of Product S decreases revenue hence Product S should be sold at split off point.

Transfers from Division A to Division B would be made using the actual marginal cost. As a result, if Division A were to make the transfers as suggested, their divisional profits would be much lower than if it were to sell both products externally at split-off point. Division B’s profits, however, would be much higher.