Question

SPD Ltd has two divisions, Tomato Division and Canning Division. Tomato Division has an annual capacity of 10 000 units of Tomato paste concentrate. Canning Division's annual requirement of Tomato paste concentrate is 8000 units. SPD Ltd requires that divisions should purchase inputs internally where available and uses a cost-plus transfer price policy, where transfer price is set at variable cost plus 25 per cent. Therefore, Tomato Division always satisfies the demand of the Canning Division first, before selling the remaining Tomato paste concentrate to external suppliers at the market price of $10 per unit. The variable cost of one unit of Tomato paste concentrate at Tomato Division is $6.
What is the difference in Tomato Division's profit under the cost-plus transfer price policy and a market-price transfer price policy?

		Tomato Division's profit is $20 000 lower under the cost-plus transfer pricing approach.
		Tomato Division's profit is $25 000 higher under the cost-plus transfer pricing approach.
		Tomato Division's profit is $20 000 higher under the cost-plus transfer pricing approach.
		Tomato Division's profit is $25 000 lower under the cost-plus transfer pricing approach.

Answer 1

Ans:

If units are sold at market price by tomato division:

Total units : 10,000

Sale price per unit : $10

Variable cost per unit : $6

Contribution over 10,000 Units : 10,000 * ($10 - $6) = $40,000

If units are sold at cost plus transfer policy by tomato division:

Total units : 10,000

Sale price per unit : $8 ( $6 + 25%)

Variable cost per unit : $6

Contribution over 10,000 Units : 10,000 * ($8 - $6) = $20,000

So Tomato Division's profit is $20 000 lower under the cost-plus transfer pricing approach.

Correct answer is option A.

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