Question

Allentown Division of Sparks Incorporated transfers its product to the Youngstown Division. The Youngstown Division can either buy the item internally or externally. The cost of purchasing the item externally is $73 per unit. The Allentown Division has just completed its annual cost updates as follows:

Direct materials	$25.00
Direct labor	18.00
Variable manufacturing overhead	6.00
Fixed manufacturing overhead	3.50
Other variable expenses	4.00
Fixed selling and administrative expenses	8.50
Total costs	$65.00
Desired return	14.00
Sales price	$79.00

The Allentown Division is operating at 60 percent of its 400,000 unit capacity.

Required:

a) What is the minimum transfer price the Allentown Division should charge for internal transfers?

b) What is the maximum price the Youngstown Division would be willing to pay?

c) Why should the Allentown Division reduce its price to the Youngstown Division?

Answer 1

In $

a. Direct Materials	25
b. Direct Labour	18
c. Variable Manufacturing Overhead	6
d. Other Variable expenses	4
e. Total Variable Cost (a + b + c + d)	53

Required:

a. What is the minimum transfer price the Allentown Division should charge for internal transfers?

Answer: $ 53

Reason: Allentown Division is expected to charge only the costs that are incidental to production (i.e.: the variable costs) and not the period cost/ fixed cost incurred.

b. What is the maximum price the Youngstown Division would be willing to pay?

Answer: $ 73

Reason: Considering individual divisions, the Youngstown Division should not be ready to pay an amount exceeding $ 73 per unit, as, it can have a purchase at the same price from outside.

c. Why should the Allentown Division reduce its price to the Youngstown Division?

Answer: (Please refer to the explanation below)

Installed Capacity 400000 units,

Capacity at operation: 240000 units (60% of 400000 units)

Capacity Unutilized: (400000 - 240000) = 160000 units.

Description	Cost per unit ($)	Total Cost (In $)
Fixed Manufacturing Overhead	3.5	840000
Fixed Selling and Administration Overhead	8.5	2040000
Total Fixed Cost (at 60% operative capacity)		2880000

Revised costs at installed capacity (i.e. 400000 units)

Description	Total Cost (In $)	Cost per unit (In $)
Fixed Manufacturing Overhead	840000	840000/400000 = 2.1
Fixed Selling and Administration Overhead	2040000	2040000/400000 = 5.1
Total Fixed Cost (at 100% operative capacity)	2880000

Reduction of cost: $ {(3.5 - 2.1) + (8.5 - 5.1)} = $ 4.8 per unit.

Reason: Allentown Division thereby can reduce the prices to the extent of $ 4.8 per unit and offer the products at $ 74.2 (79 - 4.8) per unit while maintaining its absolute profitability to Youngstown Division and exploiting its unutilized capacity.