Question

Tatooine Ltd. has two divisions. The Compound Division makes R2D2, an industrial compound, which is then transferred to the Processing Division. The Processing Division further processes the R2D2 and sells the final product to customers at $87/kg. Capacity in the Compound Division is 800,000 kg. R2D2 can be obtained on the external market at $50/kg. Data regarding the costs per kilogram in each division are presented below:

*In the Compound Division the variable overhead is 80% of the total, and in Processing variable overhead represents 65% of the total. Fixed overhead rates are based on capacity of 800,000 kg. in each division.
In addition to the manufacturing costs, the Compound Division would incur $2 per kilogram of selling costs which would be avoided on internal transfers. Similarly the Processing Division would avoid $3/kg. of ordering costs on internal purchases.
Required:
1) Calculate the operating incomes for each division assuming 800,000 kg. of R2D2 are transferred and the company uses a market transfer price.
2) Calculate the operating incomes for each division assuming 800,000 kg. of R2D2 are transferred and the company uses a transfer pricing policy based on 125% of absorption manufacturing cost.
3) What are the respective division managers preferences for method of transfer price?
4) Should the company transfer its 800,000 kg. assuming the Compound Division can sell all of its output on the external market?

Column1	Column2	Column3	Column4	Column5
		Compound Division		Processing Division
Direct Material		$                  8		$                6
Direct Labour		$                12		$              12
Manufacturing overhead*		$                28		$              18

Answer 1

a.

	Compound Division	Processing Division
Selling Price	50.00	87.00
Direct Material	(8.00)	(6.00)
Direct Material (R2D2)	-	(50.00)
Direct Labour	(12.00)	(12.00)
Variable Mfg. Overhead	(22.40)	(11.70)
Contribution margin per unit	7.60	7.30
Total Contribution Margin	60,80,000	58,40,000
Fixed Mfg. Overhead	(44,80,000)	(50,40,000)
Net Operating income	16,00,000	8,00,000

Total Operating Profit = 1600000+800000=2400000

b.

First Calculating Transfer Price of R2D2:

	Compound Division
Direct Material	8.00
Direct Labour	12.00
Variable Mfg. Overhead	22.40
Fixed Mfg. Overhead	5.60
Total Cost	48.00
125% of total cost	60.00

Calculating Operating profit:

	Compound Division	Processing Division
Selling Price	60.00	87.00
Direct Material	(8.00)	(6.00)
Direct Material (R2D2)	-	(60.00)
Direct Labour	(12.00)	(12.00)
Variable Mfg. Overhead	(22.40)	(11.70)
Contribution margin per unit	17.60	(2.70)
Total Contribution Margin	1,40,80,000	(21,60,000)
Fixed Mfg. Overhead	(44,80,000)	(50,40,000)
Net Operating income	96,00,000	(72,00,000)

Total Operating Profit = 9600000 - 7200000 = 2400000

c.

Operating Profit under different method:

Method of Tranfer Pricing	Compound Division	Processing Division
Market price	16,00,000	8,00,000
125% of absorption cost	96,00,000	(72,00,000)

For manager of compound division, since operating profit under method '125% of absorption cost' is more by $ 800000, preference will be given to that method.

Conversely, if the market price method is followed, processing division earn operating profit of 800000. However, as per absorption costing method its profit is converted into loss of 7200000. Hence, manager of processing division should give preference to market price method for calculating transfer price for R2D2

d.

Operating Profit, if entire R2D2 is sold to external market:

	Compound Division	Processing Division
Selling Price	50.00	87.00
Direct Material	(8.00)	(6.00)
Direct Material (R2D2)	-	(50.00)
Ordering Cost (R2D2)	-	(3.00)
Direct Labour	(12.00)	(12.00)
Variable Mfg. Overhead	(22.40)	(11.70)
Selling Cost	(2.00)	-
Contribution margin per unit	5.60	4.30
Total Contribution Margin	44,80,000	34,40,000
Fixed Mfg. Overhead	(44,80,000)	(50,40,000)
Net Operating income	-	(16,00,000)

Total operating profit /(loss) = (1600000)