Question

E22-11 Chen Company's Small Motor Division manufactures a number of small motors used in household and office appliances. The Household Division of Chen then assembles and packages such items as blenders and juicers. Both divisions are free to buy and sell any of their components internally or externally. The following costs relate to small motor LN233 on a per unit basis. Fixed cost per unit $ 5 Variable cost per unit Selling price per unit $35 Instructions (a) Assuming that the Small Motor Division has excess capacity, compute the minimum acceptable price for the transfer of small motor LN233 to the Household Division. (b) Assuming that the Small Motor Division does not have excess capacity, compute the min- imum acceptable price for the transfer of the small motor to the Household Division. (c) Explain why the level of capacity in the Small Motor Division has an effect on the transfer price. (a) Given excess capacity, the minimum transfer price is: (b) Given NO excess capacity the minimum transfer price is: (c) Don't forget to "answer" instruction "c":

Answer 1

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Chen Company

In transfer pricing decisions only variable costs are considered. Fixed costs are sunk costs and will continued to incur even if there is no production. So fixed cost are never considered in transfer pricing.

Answer a

If the Small motor division has excess capacity then it may charge only such price in which it is able to recover its product cost that is variable costs. So it must charge a minimum of its variable cost per unit i.e. $ 11.

Answer b

If the Small motor division does not has excess capacity then it will lose contribution on every units sold less than its sell price. So in order to maintain its operating profit it must charge a minimum of its sell price per unit i.e. $ 35.

Answer c

The level of capacity always has impact on transfer price. If a company is operating below its capacity then it means that it has unused resources and it can be used for other production activities. As the fixed cost are already incurred so whatever revenue will be generated through use of idle capacity will increase its contribution.

If the plant is operating at its full capacity, it means that plant is earning profit at its fullest. If situation arises where it has to supply units internally within the divisions then it should ensure that it will not affect its operating profit.