Question

Conglomerate Co. has two divisions. Division A manufactures widgets while Division B manufactures woblets. In the production of widgets, one of the key components is a woblet and, hence, Division A could  source its woblets temporarily directly from Division B rather than going to the external market. The following data pertains to woblets:

              Sales price $60.00 per woblet
Direct materials 22.00
Direct labor 10.00
Variable overhead 6.00
Allocated fixed costs      12.00

Division A has asked Division B to supply 4,000 woblets. Currently, Division B has the capacity to make 10,000 woblets annually.

If Division B is currently producing 10,000 woblets, what is the minimum transfer price per custom woblet that would permit Division B to maintain profit at current levels?

Answer 1

Transfer pricing requires the price to be set in such a way that product sold in open market would fetch same profit as sold to department within the organisation. The company may have various divisions and each division is responsible for earning its own level of profit. If goods are not transferred at proper price, one department will record high profit while one may incurr losses or low profit. Hence, Transfer Pricing is important.

The total capacity of Division B is 10,000 pieces. Division A requires 4,000 pieces to be supplied.

The sale price in open market for woblet is $ 60 per piece.

One thing that needs to be considered in total variable costs are $ 22 + $ 10 + $ 6 = $ 38 (material, labour and overhead).

A) Division B has market requirement of more than 6,000 pieces.

Divison B if has more then 6,000 pieces of demand that price at which it would transfer the woblet would be the market price that is $ 60 per piece. The pieces sold in open market would fetch $ 60 and hence that would be the price. Any less would sacrifice the profit of Division B. If Division B has market demand of more tahn 6,000 pieces but less than 10,000 pieces then any excess over 6,000 will be transferred at $ 60 to avoid loss of profit.

B) Division B has production capacity to left

It may so happen that Division B has less demand and it may be able to produce the requirment of Divison A. In such case the woblet may be transferred at price of $ 38 being the variable cost. Allocated fixed costs are something which has been allocated to particular department and not incurred in production. The actual cost incurred for production is the variable cost. hence, such cost should be recovered.

Any excess capacity is already not in use and in such case it would be best to transfer to goods at variable cost or at price less tahn market cost. The Division B should be allowed to make some profit and decison may be taken to transfer the woblet at price of more then $ 38 but less tahn $ 60.

Also, Division B manager may argue for allocated fixed cost to be added up and then profit element. In such case it is best to arrive at price which is win win for both division. Any price which is less then $ 60 is beneficial to Divison A since it saves its cost and any profit eanred by Division B is additional.

However, the question says that Division B profit should not get affected, hence it should be transfrred at variable cost or cost including fixed cost depending upon discussion. From the wordings of the question, it should be transferred at variable cost to Divison A.