Question

Allied Company's Small Motor Division manufactures a number of small motors
used in household and office appliances. The Household Division of Allied then assembles
and packages such items as blenders and juicers. Both divisions are free to buy and
sell any of their components internally or externally. The following costs relate to small motor LN233 on a per unit basis.

Fixed cost per unit $ 5
Variable cost per unit $11
Selling price per unit $35

Instructions

(a) Assuming that the Small Motor Division has excess capacity, compute the minimum
acceptable price for the transfer of small motor LN233 to the Household
Division.
(b) Assuming that the Small Motor Division does not have excess capacity, compute the
minimum acceptable price for the transfer of the small motor to the Household
Division.
(c) Explain why the level of capacity in the Small Motor Division has an effect
on the transfer price

Answer 1

Solution:

The capacity is play very important role in deciding the transfer price. The capacity of selling division to meet the demand of the buying division should be considered.

- If there is excess capacity, the cost of producing the good to be transferred is relevant cost.

- if there is no excess capacity, opportunity costs should be included in determining the transfer price.

Part a

Small Division has excess capacity. It means small division can meet the demand of Household division.

The transfer price is the cost of producing the goods.

The relevant cost of producing the goods is variable cost = $11 per unit.

Relevant cost is the variable cost since it is the cost which will incur in future and different under each alternative course of action.

Fixed cost is not considered as relevant since fixed cost is the period and past cost and treated as Sunk Cost for decision making.

Minimum Acceptable Transfer price for the transfer of small motor LN23 to the household division = $11 per unit

Part b –

There is not enough excess capacity. It means the capacity is not enough to meet the demand. Hence, small division must sacrifice its sales to outside customers. Hence the total contribution margin lost must be absorbed by the units to be sold to Household Division.

Lost Contribution Margin (Opportunity Cost) = Unit Selling Price 35 – Variable Cost 11 = $24 per unit

Minimum acceptable price for the transfer of the small motor to the Household Division = Relevant Cost of producing goods + Contribution Margin lost

= $11 + 24

= $35 per unit

Part C – Please refer the explanation at the beginning.

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