Question

A manufacturing company has two divisions: Motor and Pump. The Motor Division produces an intermediate good, which is a motor that can be used as an input for the Pump Division. The Motor Division also sells the motors in the open market. The Pump Division assembles the parts together to make water pumps which are sold to the consumers. The Pump Division needs an average of 10,000 motors every year. A transfer price based on the variable cost is mandated.

	Motor Division			Pump Division
Market selling price	$20		Selling price	$80
Variable cost	12		Variable cost (other than the motor)	30
Contribution margin	$  8		Variable cost of the motor (purchased from an outside supplier)	19
			Contribution margin	$31

1. If the Motor Division has no excess capacity, what is the net result of the variable cost-based transfer pricing policy?
   1. A gain of $2 per unit
   2. A loss of $1 per unit
   3. $0
   4. There is not enough information to determine the net result.

2. If the Motor Division has available capacity to handle the Pump Division’s demand, what is the net result of the variable cost-based transfer pricing policy?
   1. A gain of $7 per unit
   2. A gain of $4 per unit
   3. A loss of $7 per unit
   4. A loss of $2 per unit

Answer 1

**The question is solved from the point of view of Pump division, assuming that they have to buy the intermediate product from Motor division only

1. The correct answer is B. A loss of $1 per unit.

In the given case, as the motor division does not have excess capacity, they would want to recover the variable cost ($12 per unit) incurred for manufacturing the product, and also the contribution margin foregone ($8 per unit) which they would have earned if they would have sold their product in the market and not to Pump division. Hence, the transfer price in this case would be $20. As the pump division can acquire the intermediate product from the market at $19 per unit, acquiring the same for $20 would result in a loss of $1 per unit.

2. The correct answer is A. A gain of $7 per unit

In the given case, as the motor division has excess capacity, they would want to recover only the variable cost ($12 per unit) incurred for manufacturing the product, and not the contribution margin. Hence, the transfer price in this case would be $12 only. As the pump division can acquire the intermediate product from the market at $19 per unit, acquiring the same for $12 would result in a gain of $7 per unit.