Chapter 13 capacity limitations example 8 solution clarification required

Ignoring the transfer price for the moment, if there are capacity limitations, eg material, the way to maximise contribution is to work out for each product:

Contribution/unit of restricted resource (here material)

Then make the products (up to their maximum sales volume) in the order of this index, highest first. This gives you the best way to eke out your precious material so that it always earns the highest possible contribution per unit used. So if Product A earns $2 per kg used and the Product B $3 per kg used use the material for B first then turn to A.

In the example in the notes, labour is the restricted resource and, as the answer shows, it is better for the Division A to first dedicate labour to making Product X ($4/hr) than Product Y (only $3 per hour). Ignoring Division B, Division A would make only product X. If 10 hours of labour were removed from making X, then the loss in contribution would be $4 x 10 = $40.

To make a unit of Y, A’s own variable costs are $70. But A will also perceive an opportunity cost of $40 because it can’t then make a unit of X.

To persuade A to sell to B it will therefore have to have revenue which covers both its own variable costs and the opportunity costs. So, the required transfer cost is $70 +$40 = $110.

HTH

Great!