Question

The following question presents hypothetical data concerning transfer of cotton between departments as part of the Cotton On Group's production processes. The textile department produces cotton for use by various other production departments within the Cotton On Group. The costs incurred by the textile department to produce cotton are provided below:

	Cost per square metre
Direct materials	$2.10
Direct labour	$0.50
Variable overhead	$0.25
Fixed overhead	$0.15

The textile department can also sell cotton to external customers for $5.00 per square metre. Sales staff from the textile department are paid a sales commission of $0.10 per square metre for sales to external customers. No sales commissions are paid for transfers to internal customers.

Required

1. Provide and discuss three examples which illustrate how cost-plus pricing could be used to set the internal transfer price for cotton and how these prices impact departmental profitability.

Answer 1

Cost plus pricing method is also known as Mark-Up pricing method. In this method the company first determine the cost of the product then adding a percentage on the total cost to determine the selling price.

HEAD	COST PER SQUARE METRE
DIRECT MATERIAL	2.100
DIRECT LABOUR	0.500
VARIABLE OVERHEAD	0.250
FIXED OVERHEAD	0.150
TOTAL COST	3.000
SALES COMMISSION	0.100
TOTAL COST IF SALES OUTSIDE	3.100
ADD PROFIT	1.900
SALES PRICE	5.000

Example -1

Here the company total cost is 3.100 per square metre if it sell outside and 3.000 per square metre is it sell to internal department. So company here can save the sales commission if it sales to its own department.

In cost plus pricing method internal transfer pricing can be easy identifiable as it is a mark-up percentage on total cost. So a uniform percentage can be set for all the internal department so that there will be no issue on profit percentage.

Example -2

            In cost plus pricing method revenue is fixed on a percentage basis. So a guarantee percentage of revenue is always fixed.

Example -3

            One of the simple method to used, with only one caveat.