Question

Crede Inc. has two divisions. Division A makes and sells student desks. Division B manufactures and sells reading lamps. Each desk has a reading lamp as one of its components. Division A can purchase reading lamps at a cost of $10 from an outside vendor. Division A needs 10,300 lamps for the coming year. Division B has the capacity to manufacture 48,100 lamps annually. Sales to outside customers are estimated at 37,800 lamps for the next year. Reading lamps are sold at $12 each. Variable costs are $7 per lamp and include $1 of variable sales costs that are not incurred if lamps are sold internally to Division A. The total amount of fixed costs for Division B is $84,600.

Suppose Division B could use the excess capacity to produce and sell externally 15,450 units of a new product at a price of $7 per unit. The variable cost for this new product is $5 per unit. What should be the minimum transfer price accepted by Division B for the 10,300 lamps and the maximum transfer price paid by Division A?

What is the minimum transfer price accepted by Division B ($ per unit)?

What is the maximum transfer price paid by Division A ($ per unit)?

Answer 1

In the given case, Division A, requires 10300 lamps which it can buy from the market @ $10 per unit, so this becomes the maximum transfer price which Division A will pay to Division B, it will not pay any price beyond the market price as it will impact negatively to the Division.

Now, with regards to the Division B , The company has excess capacity of 10300 through which it can fulfill the requirement of Division A, in case excess capacity the Minimum transfer price, Division B should accept is the variable cost which is to be incurred for selling internally.

So in normal case, variable cost incurred for Division B = $7 which will be reduced with the selling cost which is not incurred when sold internally, so the net variable cost = $6, which should be the ideal transfer price in normal case, if the opportunity cost was not there.

But, here the Division B has an opportunity to use its excess capacity to produce another product, so while deciding the minimum transfer price the opportunity cost needs to be taken care and added to the variable cost so as to get the final minimum transfer price.

1.

Opportunity cost is the contribution lost if the excess capacity is not used for producing new product,

Here the varaible cost is $5 , and selling price is $7 ,

so the contribution margin per unit = Sales - variable cost = $7 - $5 = $2.

Contribution margin in amount = Contribution margin per unit * Sales units = $ 2 * 15450 = $ 30900.

So to cover this contribution , from Division A for 10300 units as follows:

Opportunity cost per unit = Required contribution / units to be transferred internally

Opportunity cost per unit = $ 30900 / 10300 = $ 3 per unit.

Opportunity cost per unit = $ 3 per unit.

So, Maximum transfer price accepted by Division B = Variable cost - variable sales cost saved + opportunity cost.

Maximum transfer price accepted by Division B = $ 7 - $1 + $3

Maximum transfer price accepted by Division B = $ 9 per unit.

2.

Maximum transfer price paid by Division A = Purchase price if it purchase from outside.

Maximum transfer price paid by Division A = $ 10 per unit.