Question

Petula Corporation’s small motor division manufactures small electrical motors that are used in the manufacture of electric appliances. The Appliance division manufactures appliances and uses one small electrical motor in each appliance. These motors are currently purchased from another company at a cost of $28. The appliance division requires 15,000 motors annually. The small motor division sells its motors to the outside market at a price of $32 each. The cost to manufacture one motor is as follows:
			Variable cost per unit	$12
			Fixed cost per unit	8
	The small motor division has the capacity to produce 40,000 motors and is currently producing and selling 32,000 motors annually.
	1.	Calculate the minimum and maximum transfer price. Should a transfer between the two divisions take place? Explain.
	2.	Assume that the division managers agree on a transfer price of $25. Calculate the incremental benefit to each division of making a transfer.

Answer 1

A market-based transfer price is based on the fair market value of the good being transferred from the selling division to the buying division. When the selling division does not have excess (idle) capacity, the market price most closely approximates the opportunity cost of the resource. Market price becomes the selling price for the selling department and purchase price for the buying department.

But when the selling division has excess capacity, the variable cost becomes the lowest price at which the selling division shall sell such excess capacity to the buying division.

1. As the small motor division has the capacity to produce 40,000 unit but it is selling only 32,000 units which means it has 8,000 units excess which it can produce. As the small motor division is selling outside at $32 and the appliance division is purchasing the same for $28, they will continue to do so for these the units which can be sold externally as small motor division would not accept anything lower than $32 and appliance division will not accept anything for more than $28. For the rest 8,000 units, minimum price will be its variable cost i.e. $12 and maximum price the market purchase price for appliance division i.e. $28.

There should be transfer of 8,000 units only.

2. Computation of Incremental profit for small motor division:

Profit before internal transfer proposal:

Revenue	A = 32,000 units*$32	$1,024,000
Expenses
Variable costs	B = 32,000 units*$12	$384,000
Fixed costs	C = 32,000 units*$8	$256,000
Revenue	D=A-B-C	$384,000

Profit after internal transfer proposal:

Revenue	A = 15,000 units*$25 + 25,000 units*$32	$1,280,000
Expenses
Variable costs	B = 40,000 units*$12	$480,000
Fixed costs	C	$256,000
Revenue	D=A-B-C	$544,000

Therefore, increase in profit = $544,000 - $384,000 = $160,000

2. As the appliance division was purchasing the electrical motor for $28 per unit which is now available at $25, therefore, incremental profit = 15,000 units * ($28-$25) = $45,000.