Question

Appropriate Transfer Prices: Opportunity Costs Plains Peanut Butter Company recently acquired a peanut-processing company that has a normal annual capacity of 4,000,000 pounds and that sold 2,900,000 pounds last year at a price of $2.00 per pound. The purpose of the acquisition is to furnish peanuts for the peanut butter plant, which needs 1,500,000 pounds of peanuts per year. It has been purchasing peanuts from suppliers at the market price. Production costs per pound of the peanut-processing company are as follows:

Direct materials $0.50

Direct labor 0.25

Variable overhead 0.11

Fixed overhead at normal capacity 0.18

Total $1.04

Management is trying to decide what transfer price to use for sales from the newly acquired Peanut Division to the Peanut Butter Division. The manager of the Peanut Division argues that $2.00, the market price, is appropriate. The manager of the Peanut Butter Division argues that the cost price of $1.04 (or perhaps even less) should be used since fixed overhead costs should be recomputed. Any output of the Peanut Division up to 2,900,000 pounds that is not sold to the Peanut Butter Division could be sold to regular customers at $2.00 per pound.

(a) Compute the annual gross profit for the Peanut Division using a transfer price of $2.00. $Answer 0

(b) Compute the annual gross profit for the Peanut Division using a transfer price of $1.04. $Answer 0

Answer 1

(a). Annual gross profit for the Peanut Division using a transfer price of $2.00 = $3840000

Explanation;

Annual gross profit for the Peanut Division using a transfer price of $2.00 will be calculated as follow;

Sale made to Peanut Butter Company (1500000 * $2)	$3000000
Sale made to open market (2500000 * $2)	$5000000
Total sales revenue	$8000000
Less: Cost (4000000 * $1.04)	($4160000)
Gross profit ($8000000 – $4160000)	$3840000

(b). Annual gross profit for the Peanut Division using a transfer price of $1.04 = $2400000

Explanation;

Annual gross profit for the Peanut Division using a transfer price of $1.04 will be calculated as follow;

Sale made to Peanut Butter Company (1500000 * $1.04)	$1560000
Sale made to open market (2500000 * $2)	$5000000
Total sales revenue	$6560000
Less: Cost (4000000 * $1.04)	($4160000)
Gross profit ($6560000 – $4160000)	$2400000