Question

Question 7

XYZ Ltd which has a system of assessment of Divisional Performance on the basis of residual income has two Division, Alfa and Beta. Alfa has annual capacity to manufacture 15,000,000 numbers of a special component that it sells to outside customers, but has idle capacity. The budgeted residual income of Beta is GHS12,000,000 while that of Alfa is GHS10,000,000. Other relevant details extracted from the budget of Alfa for the current years were as follows.

Sale (outside customers)              12,000,000 units @ GHS180 per unit

                                 Variable cost per unit                    GHS160

                                 Divisional fixed cost                       GHS80,000,000

                                 Capital employed                            GHS75,000,000

                                 Cost of capital                                      12%

Beta has just received a special order for which it requires components similar to the ones made by Alfa. Fully aware of the idle capacity of Alfa, Beta has asked Alfa to quote for manufacture and supply of 300,000 numbers of the components with a slight modification during final processing. Alfa and Beta agree that this will involve an extra variable cost of GHS5 per unit.

You are required to calculate,

1. Calculate the transfer price which Alfa should quote to Beta to achieve its budgeted residual income.
2. Indicate the circumstances in which the proposed transfer price may result in a sub optimal decision for the company as a whole.

Answer 1

All amounts are in GHS

(I think the capital employed was wrongly mentioned as 75 million instead of 750 million, if it is 75 million then already the present sales are sufficient to generate the required return. The present sales generate 160 million profit, if it is 75 million it asks for a profit of 19 million. So taken the capital employed as 750 million. Even then the profit required will be 100 million less than existing profit, so taking the budgeted residual income as 100 million. The units are also taken as remaining spare capacity of 3,000,000 units and not 300,000. If it is taken as 300,000 then transfer price must be 265 which is much higher than the sale price to outsiders. So taken as 3,000,000 units)

Revised numbers :

Residual income of Alpha = 100 million

Capital employed = 750 million

Units to be transferred = 3 million

a)

For Alpha

Sales price per unit = 180

Variable cost per unit = 160 (normal)

Contribution per unit = 20

Total contribution = 20 x 12,000,000 = 240 million

Divisional fixed cost = 80 million

Profit (at existing capacity) = 160 million

Let Y be transfer price

New contribution per unit = Y - (160+5) = (Y - 165) per unit

Cost of capital = 12%

Capital employed = 750 million

Total Cost = 750 million x 12% = 90 million

Budgeted residual income = 100 millon

Profit to be generated = 190 millon

Already existing profit = 160 million

Extra profit to be needed = 30 million

Profit from transfer to beta must be equal to 30 million

3 million numbers x (Y - 165) = 30 million

Y - 165 = 10

Y = 175

So the transfer price must be 175

b. The transfer price will become sub optimal for the company as a whole when the demand for the product of Alpha is increased, then there will not be enough spare capacity for Alpha department to manufacture and transfer units to Beta. Because the contribution on sales to outsiders (20) is higher when compared to contribution on transfer to Beta (15).