Question

EMT plc has a wide range of manufacturing activities, principally within the UK. The company operates on the divisionalized basis with each division being responsible for its own manufacturing, sales and marketing, and working capital management. Divisional chief executives are expected to achieve a target 20% return on sales.

A disagreement has arisen between two divisions which operate on adjacent sites. The Office Products Division (OPD) has the opportunity to manufacture a printer using a new linear motor which has recently been developed by the Electric Motor Division (EMD). Currently there is no other source of supply for an equivalent motor in the required quantity of 30,000 units a year, although a foreign manufacturer has offered to supply up to 10,000 units in the coming year at a price of £9 each. EMD’s current selling price for the motor is £12. Although EMD’s production line for this motor is currently operating at only 50% of its capacity, sales are encouraging and EMD confidently expects to sell 100,000 units in 2018, and its maximum output of 120,000 units in 2019.

EMD has offered to supply OPD’s requirements for 2018 at a transfer price equal to the normal selling price, less the variable selling and distribution costs that it would not incur on this internal order. OPD responded by offering an alternative transfer price of the standard variable manufacturing cost plus a 20% profit margin. The two divisions have been unable to agree, so the corporate operations director has suggested a third transfer price equal to the standard full manufacturing cost plus 15%. However, neither divisional chief executive regards such a price as fair.

EMD’s 2018 budget for the production and sale of motors, based on its standard costs for the forecast 100,000 units sales, but excluding the possible sales to OPD, is as follows: (£000) Sales Revenue (100,000 units at £12.00 each) 1,200 Direct Manufacturing Costs Bought-in materials 360 Labour 230 Packaging 40 Indirect Manufacturing Costs Variable overheads 10 Line production managers 30 Depreciation Capital equipment 150 Capitalized development costs 60 Total manufacturing costs 880 Sales and Distribution Costs Salaries of sales force 50 Carriage 20 General Overhead 50 Total costs 1000 Profit 200 Notes (1) The costs of the sales force and indirect production staff are not expected to increase up to the current production capacity. (2) General overhead includes allocations of divisional administrative expenses and corporate charges of £20,000 specifically related to this product. (3) Depreciation for all assets is charged on a straight line basis using a five year life and no residual value. (4) Carriage is provided by an outside contractor.

Required: (a) Calculate each of the three proposed transfer prices and comment on how each might affect the willingness of EMD’s chief executive to engage in interdivisional trade. (b) Outline an alternative method of setting transfer prices which you consider to be appropriate for this situation, and explain why it is an improvement on the other proposals.

Answer 1

a) Transfer Price suggested by three proposals.

1. Transfer Price suggested by EMD
Selling Price	£12.00
Less: Variable selling and distribution cost
Carriage	£0.20
Therefore Transfer Price	£11.80

Note:- Only Carriage is the variable selling and distribution cost which does not incur on internal transfer.

2. Transfer Price suggested by OPD
Direct Manufacturing Material Cost	£360,000.00
Labour	£230,000.00
Packing	£40,000.00
Indirect Manufacturing Variable overhead	£10,000.00
Total Variable Manufacturing Cost	£640,000.00
Units	100000
Total Variable Manufacturing Cost per unit	£6.40
Profit Margin on sale @20% (6.4*20/80)	£1.60
Therefore Transfer Price	£8.00

Note- 1. The Question has not mentioned whether the profit margin is calculated based on sale or cost. Therefore, I am calculating the profit margin based on the sale.

2. The line production managers are the indirect production staff which do not affect the production outcome. Therefore, line production manager cost is not considered under the calculation of total variable manufacturing cost.

3. Transfer Price suggested by Corporate Operations Director
Total manufacturing Cost	£880,000.00
Units	100000
Total Manufacturing Cost per unit	£8.80
Profit Margin on sale @15% (8.8*15/85)	£1.55
Therefore Transfer Price	£10.35

Note- The Question has not mentioned whether the profit margin is calculated based on sale or cost. Therefore, I am calculating the profit margin based on the sale.

b) Other Alternative Method:-

In 2018, EMD’s current selling capacity is 100,000 units which are 50% of its operating capacity and in 2019, EMD is also planning to consider increasing production capacity to 120,000 units.

Therefore, based on the above-mentioned information, EMD can maximum its output to 120,000 in 2018 itself and transfer extra 20,000 units to OPD at transfer price suggested by OPD i.e £ 8 each unit. As extra production of 20,000 units does not affect EMD’s fixed cost and 20% profit margin would also motivate EMD to transfer extra units to OPD.

While OPD could purchase 10,000 units from foreign manufacturers at £ 9 each unit and purchase 20,000 units from EMD at the transfer price suggested by them i.e £ 8 each unit.

The above alternative could be considered as a win-win situation for both the divisions. This alternative is an improvement than the other three proposals because (a) EMD’s operating capacity will be increased and also help them to earn extra profit @ 20%, (b) OPD’s costing can be decreased by £ 1 each unit for 20,000 units which will increase the profitability of the Division.