Question

Ultima Company has several divisions. Deep division has the following budget for next year:

Sales (50,000 units at $30)                            $1,500,000

Variable costs                                                          900,000

Contribution margin                                        $    600,000

Fixed costs                                                                400,000

Profit                                                                     $    200,000

The cost from outside suppliers of one of the components used in manufacturing Deep’s single product is $10 per unit (one component per unit). Another division of Ultima Company, the Midwest division, could sell the component to Deep. The Midwest division sells 200,000 units of the component to outsiders for $12 per unit and has variable manufacturing costs of $8 per unit and fixed costs of $2.50 per unit at that production volume.

Required: Answer the following independent questions.

1. If the Midwest division is currently operating at capacity, what is the lowest transfer price that Midwest would accept? What is the highest transfer price that Deep would pay?

2. Suppose the Midwest division has the capacity to continue its outside sales and supply all the components that Deep requires. From the points of view of Ultima Company, what is the ideal (optimal) transfer price?

3. Continuing with the facts described in question 2, Midwest and Deep negotiate a transfer price of $9 per unit for the component. Calculate the contribution margins for Deep and Midwest.

4. What would be the contribution margins of Deep and Midwest if the optimal transfer price is used instead? Does the choice of transfer price make a difference to the Ultima Company as a whole? Explain your answer.

Answer 1

Ans:

Variable cost for component for Midwest Division : $8.00

Fixed Costs : $2.50

Selling price : $12.00

1.

If Midwest division is operating at capacity lowest selling price will be : $12

Maximum Deep can pay (Payment to outsiders) : $10

2.

If there is Separate capacity optimal selling price could be Between : $8 to $10.

optimal selling price (Market price) : $10

3.

If transfer price decided at $9

Contribution margin for Midwest on these 50,000 Units:

50,000 * ( $9 - $8) = $50,000

Contribution for remaining 150,000 Units

150,000 * ($12- $8) = $600,000

Total : $50,000 + $600,000 = $650,000

Deep Divison:

Selling price 50,000 * $30 = $1,500,000

Variable costs 50,000 * $9 = $450,000

Contribution Margin : $1,500,000 - $450,000 = $1,050,000

4.

If $10 is used as transfer price :

Contribution margin for Midwest on these 50,000 Units:

50,000 * ( $10 - $8) = $100,000

Contribution for remaining 150,000 Units

150,000 * ($12- $8) = $600,000

Total : $100,000 + $600,000 = $700,000

Deep Divison:

Selling price 50,000 * $30 = $1,500,000

Variable costs 50,000 * $10 = $500,000

Contribution Margin : $1,500,000 - $500,000 = $1,000,000

Total contribution margin for the Company will remain same at Optimal transfer price and $9.

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