Question

Norex Corporation is a manufacturer of electronic equipment. The large, diversified organization is decentralized and has a number of different divisions. The components division makes electronic components that can be sold either internally to the equipment division or sold to outside customers. Currently, the components division is producing a tiny motor that is often used to run fans to cool equipment. The variable cost of making the motors is $10 per unit, the fixed cost is $5, and the market price is $20. Production is 100,000 units.

The equipment division uses the motor when assembling small fans that are sold to computer manufacturers. Currently, the equipment division sells 50,000 fans. The additional variable cost for processing the motors into fans is $8 per unit. Top management is re-evaluating Norex’ transfer pricing policies. The managers are considering the following price options: variable cost, fully allocated cost, and market price.

a) Assume the components division has enough capacity to meet both internal and external demand. If the transfer price is set using the opportunity cost for the components division, what transfer price would be most appropriate?

b) Assume the components division is operating at full capacity and could sell more units to the outside market. If the transfer price is set using the opportunity cost for the components division, what transfer price would be most appropriate?

Answer 1

Req A: When the selling division i.e. Component division is having enough capacity to fulfill the demands, then the transfer price shall be fixed at variable cost of producing the motors for the component division i.e. $ 10 per unit. As the only cost incurred in making the motors is $10.00 per unit and there is no loss of sales to outsiders, therefore, from the viewpoint of Component division, the minimum price to be fixed as transfer price shall be $10.00 per unit i.e. Variable cost.

Req B: When the component division is already operating at the full capacity, this means supplying the motors to the other division will result in loss of contribution to be earned from outsiders. Therefore, from the viewpoint of component division, they must fix the transfer price at such rate which will cover their variable cost of manufacturing the motors (i.e. $ 10.00 per unit) as well as bear the loss of contribution (i.e. $10 per unit) which would have been earned from outside customer. Therefore, the transfer price shall be market price of the motors.