Calculating the effects of a transfer pricing system on divisional and company profits
Division A of a large divisionalized organization manufactures a single standardized product. Some of the output is sold externally whilst the remainder is transferred to Division B where it is a subassembly in the manufacture of that division’s product. The unit costs of Division A’s product are as follows:
|
|
(£) |
|
Direct material |
4 |
|
Direct labour |
2 |
|
Direct expense |
2 |
|
Variable manufacturing overheads |
2 |
|
Fixed manufacturing overheads |
4 |
|
Selling and packing expense – variable |
1 |
|
|
15 |
Annually 10 000 units of the product are sold externally at the standard price of £30.
In addition to the external sales, 5000 units are transferred annually to Division B at an internal transfer charge of £29 per unit. This transfer price is obtained by deducting variable selling and packing expense from the external price since this expense is not incurred for internal transfers.
Division B incorporates the transferred-in goods into a more advanced product.-The unit costs of this product are as follows:
|
|
(£) |
|
Transferred-in item (from Division A) |
29 |
|
Direct material and components |
23 |
|
Direct labour |
3 |
|
Variable overheads |
12 |
|
Fixed overheads |
12 |
|
Selling and packing expense- |
1 |
|
variable |
80 |
Division B’s manager disagrees with the basis used to set the transfer price. He argues that the transfers should be made at variable cost plus an agreed (minimal) mark-up since he claims that his division is taking output that Division A would be unable to sell at the price of £30.
Partly because of this disagreement, a study of the relationship between selling price and demand has recently been made for each division by the company’s sales director. The resulting report contains the following table:
Customer demand at various selling prices:
|
Division A |
|
|
|
|
Selling price |
£20 |
£30 |
£40 |
|
Demand |
15000 |
10000 |
5000 |
|
Division B |
|
|
|
|
Selling price |
£80 |
£90 |
£100 |
|
Demand |
7200 |
5000 |
2800 |
The manager of Division B claims that this study supports his case. He suggests that a transfer price of £12 would give Division A a reasonable contribution to its fixed overheads while allowing Division B to earn a reasonable profit. He also believes that it would lead to an increase of output and an improvement in the overall level of company profits.
You are required:
(a) to calculate the effect that the transfer pricing system has had on the company’s profits, and
(b) to establish the likely effect on profits of adopting the suggestion by the manager of Division B of a transfer price of £12.