Question

ABC Cycle makes bicycles for people of all ages. The frames division makes and paints the frames and supplies them to the assembly division where the bicycles are assembled. ABC Cycle is a successful and profitable corporation that attributes much of its success to its decentralized operating style. Each division manager is compensated on the basis of division operating income. The assembly division currently acquires all its frames from the frames division. The assembly division manager could purchase similar frames in the market for $480. The frames division is currently operating at 80% of its capacity of 4,000 frames (units) and has the following details: Direct materials ($150 per unit x 320 units) Direct manufacturing labour ($60 per unit x 3,200 units) Variable manufacturing overhead costs ($30 per unit x 3,200 units) Fixed manufacturing overhead costs $480,000 192,000 96,000 $624,000 All the frames division’s 3,200 units are currently transferred to the assembly division. No frames are sold in the outside market. The frames division has just received an order for 2,000 units at $450 per frame that would utilize half the capacity of the plant. The order has to be either taken in full or rejected totally. The order is for a slightly different frame than what the frames division currently makes but takes the same amount of manufacturing time. To produce the new frame would require direct materials per unit of $100, direct manufacturing labour per unit of $48, and variable manufacturing overhead costs per unit of $30. Required: 1. From the viewpoint of ABC Cycle as a whole, should the frames division accept the order for the 2,000 units? 2. What range of transfer prices result in achieving the actions determined to be optimal in question 1 if division managers act in a decentralized manner? 3. The manager of the assembly division has proposed a transfer price for the frames equal to the full cost of the frames including an allocation of overhead costs. The frames division allocates overhead costs to engines on the basis of the total capacity of the plant used to manufacture the frames. a. Calculate the transfer price for the frames transferred to the assembly division under this arrangement. b. Do you think that the transfer price calculated in question 3a will result in achieving the actions determined to be optimal in question 1, if division managers act in a decentralized manner? c. Comment in general on one advantage and one disadvantage of using full costs of the producing division as the basis for setting transfer prices. 4. Now consider the effect of income taxes. a. Suppose the assembly division is located in a country that imposes a 10% tax on income earned within its boundaries, while the frames division is located in a country that imposes no tax on income earned within its boundaries. What transfer price would be chosen by Speed Racer to minimize tax payments for the corporation as a whole? Assume that only transfer prices that are greater than or equal to full manufacturing costs and less than or equal to the market price of “substantially similar” frames are acceptable to the taxing authorities. b. Suppose that ABC cycle announces the transfer price computed in question 4a to price all transfers between the frames and assembly divisions. Each division manager then acts autonomously to maximize division operating income. Will division managers acting in a decentralized manner achieve the actions determined to be optimal in question 1? 5.Consider your responses to questions 1 to 4 and assume the frames division will continue to have opportunities for outside business as described in question 1. What transfer-pricing policy would you recommend Speed Racer use and why? Would you continue to evaluate division performance on the basis of division operating incomes?

Answer 1

1	Considering ABC as a whole,
	Cost of Operating Frames Division is as under:
		Per unit
	Direct material	150
	Direct Labour	60
	Variable Overheads	30
	Variable Cost per unit	240
	3200 units are supplied to Assembly department
	Thus, Total Variable Cost	=240 * 3200
		=768000
	Total Cost of the department
	Total Variable Cost	768000
	Fixed Costs	624000
	Total Cost	1392000
	Cost per unit transferred to assembly	435
	If the company accepts the order of supplying 2000 frames:
	The Assembly division will have to procure partially from outside
	Frames Division Capacity	4000
	(-) Utilised for the order	2000
	Balance capacity	2000
	Assembly Division Requirement	3200
	(-) Balance Capacity of Frames Div	2000
	Procurement from outside	1200
	Additional procurement cost for Assembly division:
	per unit	=480-435		=45
	for 1200 units	=1200*45		=54000
	Contribution from each unit of outside order (2000 units)
	Sales proceeds per unit	450
	(-) Direct Material per unit	100
	(-) Direct Labour per unit	48
	(-) Variable Cost per unit	30
	Contribution per unit	272
	Total Contribution (2000 units)	=2000*272		=544000
	Differential gain to the company on account of the order
	=additional contribution from the order (-) additional procurement cost for Assembly division
	=544000 - 54000
	=490000
	Since there is a net gain from above, the order must be accepted.
2	Acting in a decentralised manner, the frames division shall quote the assembly division according to the following:
	Profit of Frames Division from the 2000 units order:
	No of Units	2000
	Contribution per unit	272
	Total Contribution	544000
	(-) Fixed cost allocated to the order	312000		=624000 * 2000/4000
	Net Profit from the order	232000
	In case the Frames division is to reject the 2000 units order and supply only internally, the minimun transfer price shall be:
	Total Cost of 3200 units	1392000		(as above)
	(+) Profit from outside order, now foregone	232000
	Total Price for 3200 units	1624000
	Transfer price per unit	507.5		=1624000 / 3200
3	As per absorption costing:
a	Fixed overheads per unit	=624000 / 4000		=156
	Add: Variable Cost per unit			=240
	Total transfer price			=396
b	No. Since the total capacity of the frames division is 4000 vis-à-vis the order from the assembly divisionof 3200 units
	Here, there will be a gap of (156 * 800) = 124800 due to non-utilisation of capacity arising due to non-allocation of fixed costs partially.
c	Advantage: The entire cost gets fathomed. Fixed cost, unlike variable cost, does not depend on no. of units under production.
	Some portion of fixed cost is incurred even if there is no production at all.
	In a case of under utilisation of capacity, there will be some portion of fixed cost which will not be considered for fixing price.
	Disadvantage: This method loses out when it comes to competitive product pricing. It focus on fixed costs of the department, which more or less are not changeable in the short term.