Alton division (A) and Birmingham division (B) are two manufacturing divisions of Conglom plc. Both of these divisions make a single standardized product; A makes product I and B makes product J. Every unit of J requires one unit of I.
The required input of I is normally purchased from division A but sometimes it is purchased from an outside source.
The following table gives details of selling price and cost for each product:
Division B is currently achieving a rate of return well below the target set by the central office. Its manager blames this situation on the high transfer price of product I. Division A charges Division B for the transfers of I at the outside supply price of £30. The manager of division A claims that this is appropriate since this is the price ‘determined by market forces’. The manager of B has consistently argued that intra group transfers should be charged at a lower price based on the costs of the producing division plus a ‘reasonable’ mark-up.
The board of Conglom plc is concerned about B’s low rate of return and the divisional manager has been asked to submit proposals for improving the situation. The board has now received a report from B’s manager in which he asks the board to intervene to reduce the transfer price charged for product I. The manager of B also informs the board that he is considering the possibility of opening a branch office in rented premises in a nearby town, which should enlarge the market for product J by 5000 units per year at the existing price. He estimates that the branch office establishment costs would be £50 000 per annum.
You have been asked to write a report advising the board on the response that it should make to the plans and proposals put forward by the manager of division B. Incorporate in your report a calculation of the rates of return currently being earned on the capital employed
by each division and the changes to these that should follow from an implementation of any proposals that you would recommend.
SOLUTION
The report should include an estimate of divisional profits and return on investment (ROI) based on current demand:
Assuming there is a single market price of £30, the current system is motivating correct decisions since both managers are encouraged to expand output. However, the current transfer pricing system is causing motivational problems because it under estimates the contribution which division B makes to overall company profits. In other words, the current system results in an inadequate measure of divisional performance.
Division A has 30 000 units capacity available to meet the demand of Division B. Therefore Division A can meet the demand of Division B without forgoing any sales to outside customers. Consequently the relevant cost of the transfers is £15 per unit variable cost. A transfer price of £15 per unit would be unfair to Division A, since internal transfers would not provide any contribution to fixed costs.
A possible solution is to set the transfer price at £15 per unit, and Division B should also pay Division A an annual lump sum contribution to cover the fixed costs of Division A. Total output of Division A is 125 000 units, consisting of 100 000 units outside sales and 25 000 units internal transfers. Therefore 20% of Division A’s capacity is devoted to Division B, and thus the lump sum payment should be £100 000 (20% of £500 000 fixed costs). If in any year it is anticipated that demand in the external market will be in excess of Division A’s capacity, the transfer price should be set at the prevailing market price
It is assumed that additional sales of 5000 units of product J can only be obtained if a new branch is opened. The incremental costs to the company are £175 000 (£125 000 variable cost + £50 000 establishment costs) and the incremental revenues are £250 000. Therefore total company profits will increase by £75 000 if the new branch is opened. However, with the present transfer pricing system Division B will regard the transfer price as an incremental cost. Consequently contribution will be £10 per unit and the annual establishment costs of £50 000 will equal Division B’s total contribution of £50 000. Therefore Division B profits will remain unchanged and the manager will not be motivated to open the new branch. If the new branch is opened then, with the present transfer pricing system, the £75 000 additional profit will be allocated to Division A.
A transfer price system consisting of £15 variable cost plus a lump sum payment is recommended. The revised transfer pricing system will motivate the manager of Division B to open the new branch. The divisional profit calculations (without the new branch) based on the proposed transfer pricing system are as follows