Man Co. (Mar/Jun 2016 amended)-Transfer pricing

4 A manufacturing company, Man Co, has two divisions: Division L and Division M. Both divisions make a single standardised product. Division L makes component L, which is supplied to both Division M and external customers. Division M makes product M using one unit of component L and other materials. It then sells the completed product M to external customers. To date, Division M has always bought component L from Division L. The following information is available: Selling price Direct materials: Component L Other (12) (17) Direct labour Variable overheads Selling and distribution costs Contribution per unit before fixed costs Annual fixed costs Annual external demand (units) Capacity of plant (6) (9) (2) (3) (4) (1) ––– ––– 16 26 ––– ––– $500,000 $200,000 160,000 120,000 300,000 130,000 Component L Product M $$ 40 96 Division L charges the same price for component L to both Division M and external customers. However, it does not incur the selling and distribution costs when transferring internally. Division M has just been approached by a new supplier who has offered to supply it with component L for $37 per unit. Prior to this offer, the cheapest price which Division M could have bought component L for from outside the group was $42 per unit. It is head office policy to let the divisions operate autonomously without interference at all. Required: (a) Calculate the incremental profit/(loss) per component for the group if Division M accepts the new supplier’s offer and recommend how many components Division L should sell to Division M if group profits are to be maximised. (3 marks) (b) Using the quantities calculated in (a) and the current transfer price, calculate the total annual profits of each division and the group as a whole. (6 marks) (c) Discuss the problems which will arise if the transfer price remains unchanged and advise the divisions on a suitable alternative transfer price for component L. (6 marks) In the part (b) question, while solving for Division M, the selling price has been taken as $27 and $1 of selling and distribution has been deducted as it is further cost to sell to external customers. Can you please tell me how was $27 calculated, since $96 is the selling price for division M.