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Ox Co. has two divisions, A and B. Division A makes a component for air conditioning units which it can only sell to Division B. It has no other outlet for sales.
Current information relating to Div A is as follows:
Marginal cost per unit $100
Transfer price of component $165
Total production and sales of the component each year 2,200 units
Specific fixed costs of Division A per year $10,000Cold Co has offered to sell the component to Div B for $140 per unit. If Div B accepts this offer, Div A will be closed.
If Div B accepts Cold Co’s offer, what will be the impact on profits per year for the group as a whole?
Answer:
increase in variable costs per unit from buying in is $40 ($100-$40)total increase in variable costs = $40 x 2200 units = $88000
$88000 – specific fixed cost = $88000 – $10000 = $78000 (decrease)
Dear Sir,
I cannot understand this answer. Can you help please?
Why are we interested in the increase in variable costs only?
Why have we not brought the transfer price of $165 into the equation, as the company as a whole will be losing this sale?Dude i was about to post the same question from the kaplan kit.
Why we are not thinking the other way around like if division B is buying from outside it is saving $25(160-140) that,s 2200*25+10000 =65000 increase in profits so 6 should be the answer.
But why only the marginal costs were being considered?As far as the company as a whole is concerned, the transfer price is not relevant – it is income to A but a cost to B. There is only one company, and currently the variable cost to the company is $100 per unit.
If they buy from Cold, then the cost to the company will be $140 per unit. Therefore the company will be paying an extra $40 per unit, or in total an extra $88,000.
The question has not considered just the variable costs!! If they do buy from Cold, the division A will close and this will save the company $10,000.
So the net extra cost is 88,000 – 10,000 = 78,000 and therefore the profits will fall by this amount.
I do suggest that you watch my free lectures on transfer pricing. The lectures are a complete free course for Paper F5 and cover everything needed to be able to pass the exam well.
@johnmoffat said:
As far as the company as a whole is concerned, the transfer price is not relevant – it is income to A but a cost to B. There is only one company, and currently the variable cost to the company is $100 per unit.If they buy from Cold, then the cost to the company will be $140 per unit. Therefore the company will be paying an extra $40 per unit, or in total an extra $88,000.
The question has not considered just the variable costs!! If they do buy from Cold, the division A will close and this will save the company $10,000.
So the net extra cost is 88,000 – 10,000 = 78,000 and therefore the profits will fall by this amount.
I do suggest that you watch my free lectures on transfer pricing. The lectures are a complete free course for Paper F5 and cover everything needed to be able to pass the exam well.
But just like the cost of B is impacting the whole group profit why not the income of A not impacting on the whole group profit?
This is confusing“The transfer price is not relevant – it is income to A but a cost to B.”
So essentially the two cancel each other out. The $165 is income to A and a cost to B. Without division A, the income of A no longer exists which means the cost to B will no longer exist ($165).
So, (my way of looking at it is this):
Since there’s no more division A, that means theres no marginal cost of $100
total marginal cost = $100 * 2200 = $220,000 (a saving)
No fixed cost any longer = $10000 (a saving)BUT B is now buying 2200 units from Cold Co at $140
Total cost = $140 * 2200 = $308,000 (a cost)
Difference :
308,000 – 220,000 – 10,000 = $78,000Hope this helps
@jayped said:
“The transfer price is not relevant – it is income to A but a cost to B.”
So essentially the two cancel each other out. The $165 is income to A and a cost to B. Without division A, the income of A no longer exists which means the cost to B will no longer exist ($165).
So, (my way of looking at it is this):
Since there’s no more division A, that means theres no marginal cost of $100
total marginal cost = $100 * 2200 = $220,000 (a saving)
No fixed cost any longer = $10000 (a saving)BUT B is now buying 2200 units from Cold Co at $140
Total cost = $140 * 2200 = $308,000 (a cost)
Difference :
308,000 – 220,000 – 10,000 = $78,000Hope this helps
Thanks buddy now it definitely makes more sense.
But still like to many other students the topic of transfer pricing is confusing and difficult to grasp.Jayped: Please do not answer in this forum – it is the Ask the Tutor Forum, and you are not the tutor 🙂 (Although please do help people in the other F5 forum).
myacca1990: Can I suggest again that you watch my free lectures on transfer pricing. The topic is neither confusing nor difficult to grasp if you watch the lectures (as many other students will agree ) 🙂
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