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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 Division A is as follows:
Marginal cost per unit $100
Transfer price of the component $165
Total production and sales of the component each year 2,200 units
Specific fixed costs of Division A per year $10,000
Cold Co has offered to sell the component to Division B for $140 per unit. If Division B accepts this offer, Division A
will be closed.
If Division B accepts Cold Co’s offer, what will be the impact on profits per year for the group as a whole?My question is If Div B accepts the price of $140 per unit, it is actually making a savings of (165-140)= $ 25 per unit. This is because before Division A was charging 165 for the component? So it has an increase in profits on that basis. please correct me if the above is not well interpreted
The question asks for the impact on the profit of the whole group i.e. A and B together.
At the moment the group is paying $100 to produce each unit, but if the group buys from Cold Co they will be paying $140. So an extra $40 per unit or in total $88,000 (2,200 x $40).
However because they would close division A, the group will save the fixed costs of $10,000.
So a net reduction in profit of $78,000.
(The transfer price is not relevant – it is income of one division but a cost of the other division.)
My free lectures on transfer pricing will help you. The lectures are a complete free course for Paper F5 and cover everything needed to be able to pass the exam well.
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