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Division M manufactures product R incurring a total cost of £30 per unit. Fixed costs represent 40% of the total unit cost.
Product R is sold to external customers in a perfectly competitive market at a price of £50 per unit. Division M also transfers product R to Division N. If transfers are made internally then Division M does not incur variable distribution costs, which amount to 10% of the variable costs incurred on external sales.
The total demand for product R exceeds the capacity of Division M.Question: From the point of view of the company as a whole, enter the optimum price per unit at which Division M should transfer product R to Division N.
Division M – variable cost is £18 (60% x £30)
Variable saving on internal transfer £1.80 (10% x £18)
Division M is operating at full capacity and can sell unit to an external market for £50 – so for every unit it transfers internally it will lose £50 revenue but save £1.80 – so the optimal transfer price is £48.20 (£50 – £1.80).Another way of looking this is, for every unit transferred, Division M will:
Incur variable cost £18
Forego contribution £32 (£50 – £18) – this is an opportunity cost
Save -£1.80
i.e. £48.20Hello Mrs Kim. Thank you very much for the answer. I cannot understand the different scenarios when there is a perfectly competitive market, when there is surplus and excess capacity. In this scenario there is excess capacity ( meaning no spare capacity). Can you tell me what will be the point of view of Division N? I need illustrations from both the point of views of the selling division as well as the buying division to be able to understand.
If you can recommend a book on these different scenarios, it will be better for me to understand. What do you recommend Mrs Kim?
Thank You.I think perhaps you are confusing demand and capacity.
1. If capacity > demand there is “excess capacity”
2. If demand > capacity there is excess demand i.e. NO spare capacityLet me summarise referring to the selling division as S, the buying division as B, the transfer price as TP and marginal cost (assumed to be variable cost) as VC.
In situation 1:
S will be prepared to sell to B as long as TP is not less than S’s VC. Min TP S could accept = VC (S would actually be indifferent as it would make zero contribution from selling internally).
B will prepare to buy from S as long as TP + B’s VC does not exceed the revenue (X) it will make from selling the final product. So max TP B could accept is X – B’s VC.
In situation 2:
S can sell every unit at the market price so it will not sell for less to B unless there is some saving to be made; it will sell for TP = Market price – saving in VC.
However, B will only buy at that price if, together with it’s own VC, it will earn a contribution.What you have to remember is that this is a decision-making topic – and all decisions should be based on contribution; positive is “good”, negative is “bad” and zero is indifferent.
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