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QUESTION
The production division of Abel Co has the following standard unit costs for the production of an
electronic component:
Direct material $2.00
Direct labour $2.50
Variable overheads $1.50
Fixed overheads are expected to be $300,000 and maximum capacity is 100,000 units.
The production division currently makes and transfers all 100,000 components to the retail division,
which completes the assembly and sells it to individual consumers for $15, after incurring additional
costs of $2.50 per unit. The current transfer price policy is full cost plus 30%.
The production division has been offered the chance to sell all the components it can produce to a
commercial buyer who is willing to pay $11 per unit. The retail division can source components
externally at a price of $11.50. Assume the maximum demand for the retail division’s product is
100,000 units.What is the minimum transfer price that will ensure Abel Co maximises company profit, given
the offer from the commercial buyer?
?$12.50
?$11.00
?$9.00
?$8.50ANSWER
• $11
If capacity is limited, it is better for the company to sell 100,000 components to the individual
consumer: contribution = $15-$6-$2.50 = $6.50 per unit, than to the commercial buyer at a
contribution of $5 ($11-$6)
The production division will therefore want the TP to be at least $11.
The retail division will accept transfers provided the cost is less than its incremental net revenue
$15-$2.50 = $12.50My question is, did they take $11 because that way they loose the lease contribution? And is the retail division price od 12.50 the maximum transfer price?
The minimum transfer price is always the marginal cost ($6) plus any lost contribution ($5), and so is $11.
The maximum transfer price is always the lower of the net marginal revenue ($12.50) and any external purchase price ($11.50).
I do suggest that you watch my free lectures on transfer pricing where I explain all of this.
The lectures are a complete free course for Paper PM and cover everything needed to be able to pass the exam well.
Yes I do understand the formula for maximum and minimum transfer. But how did they compare commercial buyer with individual buyer?
There is no need to do that, but it just confirms that the company will make more contribution by producing and selling the units to individual buyers than they will by selling to commercial buyers and that therefore the transfer price should be fixed at a level that encourages the managers to do this. It is just as I explain in my lectures.
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