Question

Perfumes Ltd has two divisions: the Perfume Division and the Bottle Division. The company is decentralised and each division is evaluated as a profit centre. The Bottle Division produces bottles that can be used by the Perfume Division. The Bottle Division's variable manufacturing cost per unit is $3.00 and shipping costs are $0.20 per unit. The Bottle Division's external sales price is $4.00 per unit. No shipping costs are incurred on sales to the Perfume Division. The Perfume Division can purchase similar bottles in the external market for $3.50. The Bottle Division has sufficient capacity to meet all external market demands in addition to meeting the demands of the Perfume Division. Required: a) Using the general rule, determine the minimum transfer price. b) Assume the Bottle Division has no excess capacity and can sell everything produced externally. Would the transfer price change? c) Assume the Bottle Division has no excess capacity and can sell everything produced externally. What is the maximum amount Perfume Division would be willing to pay for the bottles? d) When is it more appropriate to use market-based transfer price rather than cost-based transfer price? (1 mark)

Answer 1

a. The Bottle Division has sufficient capacity to meet all external market demands in addition to meeting the demands of the Perfume Division. Using the general rule, the minimum transfer price from the Bottling Division to the Perfume Division would be equal to variable manufacturing cost per unit i.e $3.00

b. Assume the Bottle Division has no excess capacity and can sell everything produced externally. Using the general rule, the transfer price from the Bottling Division to the Perfume Division would be: $3.00 - $0.20 = $2.80 per unit

c) Assume the Bottle Division has no excess capacity and can sell everything produced externally. What is the maximum amount Perfume Division would be willing to pay for the bottles will be the price the Perfume Division can purchase similar bottles in the external market i.e $3.50

d) When is it more appropriate to use market-based transfer price rather than cost-based transfer price?

Market-based transfer price is more appropriate when divisions operate at capacity and there are no market transaction costs. Market based transfer prices are most appropriate for common high-cost and high-volume standardized services.