Question

Langford Ltd. operates a chain of restaurants. The restaurants have performed very well, having established a reputation for affordable, value for money offerings and child-friendly facilities.

In seeking new growth opportunities, the company has embarked on a strategy of acquiring existing successful companies to supply key materials and ingredients to their restaurants. The rationale for this strategy is to secure supplies at more affordable prices as well as exploiting opportunities within these markets more generally.

With the growth of the company, it has become necessary to decentralize decision-making through the creation of two divisions, Supply Services and Restaurants. Each division is treated as an investment center with divisional managing directors being evaluated on the basis of annual return on investment (ROI). Each division in turn consists of a number of business units treated as profit centers for performance management.

Megaco (Pty) Ltd., which manufactures a variety of cheese products, has recently been acquired by Langford Ltd. Megaco’s main customer base is medium sized independent retailers, but it is looking to expand its market and thereby utilize its excess capacity.

A key ingredient of many of the restaurant meals is standard cheddar cheese which is procured centrally by the Restaurant division at a favourable price owing to volume discounts negotiated with the existing supplier.

In line with Langford’s acquisition strategy of securing restaurant supplies at more affordable prices; the Managing Director of Restaurant division have been encouraged to meet the Chief Executive Officer (CEO) of Megaco and discuss mutually beneficial ways of transacting internally. The restaurants currently purchase and use 2,500 kgs of cheddar cheese monthly and pay $12.00 per kg.

The Managing director of Restaurant division, together with Megaco’s CEO have met on two occasions and, although they recognized the benefit to the company as a whole from transacting internally, have not yet reached agreement on a transfer price for standard cheddar cheese.

Megaco currently sells the cheese to its existing customers at $15.00 per kg and its CEO is reluctant to reduce the price for the restaurants. However, in the interests of the company as a whole, he has offered to reduce his normal mark-up and hence discount the existing price by 10%. As he explained: ‘This is the best I can do, after all I have to cover my full costs and make a fair profit.' The Restaurant’s Managing Director was not prepared to accept this price and, although Langford Ltd.’s executive management team was disappointed that no deal had been struck, chose not to interfere.

Megaco’s standard cheddar cheese monthly manufacturing capacity and related costs are as follows:

Maximum capacity (kgs)	12,000
Current utilization (kgs)	8,000
Variable costs per kg:
Product cost	$6.00
Selling, administration and general expenses	$3.00
Monthly fixed costs in respect of providing the maximum capacity:
Production	$15,000
Selling, administration and general expenses	$5,000

Required:

1. From the perspective of the overall company, determine the range of transfer prices for cheddar cheese that should be negotiated between Megaco and Restaurant Division. Explain your answer. (1 mark)
2. Assume after further negotiation, Megaco and the Restaurant division agree on a transfer price of $10.00. If 2500 kgs per month are transferred internally at this price, what will be the increase in overall monthly profit for Langford Kitchen? Show your calculations to support your answer.       (1.5 marks)

3. Assume that Megaco and the Restaurant Division agree on a transfer price of $10.00 per kg cheddar cheese:
4. What will be the increase in monthly profit for Restaurant division? Show your calculations to support your answer.     (1.5 marks)
5. Calculate Megaco’s additional monthly contribution margin             (1.5 marks)
6. Five months after Megaco started supplying cheddar cheese to the Restaurant Division, its existing retail customers increased their monthly orders of standard cheddar cheese by 2,500 kgs at the normal price of $15.00 per kg. Taking into account this change in Megaco's circumstances, if it continues supplying 2,500 kgs of standard cheddar cheese monthly to the Restaurant Division, Megaco's minimum acceptable transfer price per kg will be? Show your calculations to support your answer.    (2.5 marks)

Answer 1

Quantity required by the Restaurant Division =2500Kgs

Current Sales of Megaco=8000 Kgs

Available Capacity=12000 Kgs

Current Product Cost=8000*$6=$48,000

Fixed Cost of Production=$15,000

Variable Cost of Production =(48000-15000)=$33000

Variable Production cost per Kg=33000/8000=$4.125

Current Selling , admin and General Cost=8000*$3=$24000

Fixed Selling, admn and general cost=$5000

Variable Selling, admin and general cost=(24000-5000)=$19000

Variable Selling, admin and general cost per Kg=19000/8000=$2.375

Total Variable Cost per Kg=4.125+2.375=$6.5

Marginal Cost of Producing additional 2500 Kgs for the Restaurant Division=$6.5 per Kg

Cost of Purchasing by the Restaurant Division from outside =$12 per Kg

From the perspective of the overall company, the range of transfer prices for cheddar cheese that should be negotiated between Megaco and Restaurant Division: $6.5 to $12 per Kg

Assume after further negotiation, Megaco and the Restaurant division agree on a transfer price of $10.00. If 2500 kgs per month are transferred internally at this price, what will be the increase in overall monthly profit for Langford Kitchen

Increase in Overall Monthly Profit:

Savings per Kg =(12-10)=$2

Increase in Monthly Profit for Restaurant Division =2*2500=$5000

Additional Profit for Megaco=(10-6.5)*2500=$8750

Overall increase in monthly Profit =5000+8750=$13,750

AFTER 5 MONTHS:

Total Sales by Megaco at $ 15 per kg=8000+2500=10500Kgs

Capacity=12000Kgs

Capacity available for supply to Restaurant Division =12000-10500=1500Kgs

Acceptable Minimum sales Revenue from Restaurant Division=1500*$10+(2500-1500)*$15

Acceptable Minimum sales Revenue from Restaurant Division=1500*$10+1000*$15=$30000

Minimum acceptable price per Kg=30000/2500=$12 per Kg