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Dear Tutor,
I have a question regarding Q1.
It says : A local engineering firm has quoted a flat price of $200 per warranty service repair.
So it is the M/S or Service division going to pay for the $200 per unit? If it is Service division going to pay, then it should be a cost to Service division isn’t? Why it appear as Revenue on the answer? I am very confused on this.
Thank you in advance.
The $200 quoted by the local engineering firm is an indication of the market-price based transfer price.
Currently the service division earns a fixed $10m from warranty work.
There are 440,000 x 9% = 39,600 warranty claims and if the service division were to charge the market price it would earn $200 x 39,600 = $7,920,000 only (see answer appendix). The service division can still make a profit (though reduced) and the profit will provide motivation to still do this work.
However, as the answer makes clear, a reduced market price might be fairer to M/S (because of cost savings if the work is done internally).
The service division can decide whether to do the work itself (incurring its variable costs) or if it should sub-contract the work to free up resources to carry out more profitable work.
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