Question

Setting Transder Prices-Market Price versus Full Cost Ardmore, Inc, manufactures heating and ar conditioning units in its six divisions. One division, the Components Division, produces electronic components that can be used by the other five. All the components produced by this division can be sold to outside customers; however, from the beginning, about 70 percent of ts output has been used internally. The current polcy requires that all intemal transfers of components be transferred at full cost. Recently, Cynthia Busby, the new chief executive officer of Ardmore, decided to investigate the transfer pricing policy. She was concermed that the aurrent method of pricing internal transfers might force decisions by divisional managers that would be suboptimal for the firm. As part of her inquiry, she gathered some information conceming Part 4CM, used by the Small AC Division in its production of a window ar conditioner, Model 7AC The Seall AC Division sells 10,000 units of Model 7AC each year at a unit price of $58. Gven aurent market conditions, this is the maximum price that the division can charge for Model 7AC. The cost of manufacturing the air conditioner is computed as follows: $6.45 Part 4CM 23.00 Direct materials Direct labor 15.00 Variable overhead 3.50 Fixed overhead 6.50 $54.45 Total unit cost The window unit is produced efficiently, and no further reduction in manudacturing costs is possble. The manager of the Components Division indicated that he could sell 10,000 unts (the division's capacty for this part) of Part 4CM to outside buyers at $12 per unit. The Small AC Division could also buy the part for $12 from external supplers. The following detail on the manufacturing cost of the component was provided $2.75 Direct materials Direct labor 0.80 Variable overhead 1.10 Foxed overhead 1.80 Total unit cost $6.45 Required: 1. Compute the firmwide contribution margin associated with Part 4CM and Model 7AC. Also, compute the contrbution margin earned by each division Contribution margin mnonente.Deeion.Dart ACM

Answer 1

Solution to Que1.

As per the existing transfer policy, component division sold 70% of its output internally at FULL COST. So

Capacity of Component division to make Part 4CM = 10,000 units (given in Que.)

Units transferred to Small AC division (70% of output)= 10000* 70% = 7000 units @ $6.45 per unit i.e.total cost of each part.

Remaining parts (10,000-7,000) = 3000 sold to external market @ $12 per unit.

Contribution margin of Component division-Part 4CM = (Selling price - total cost)* 3000 units

=(12-6.45)*3000 = $16,650.

For small AC division, 10,000 units of part 4CM is needed to manufacture 10,000 window ac Model 7AC. 7000 units of Part 4CM are purchased from Component division @ $6.45 per unit and remaining 3,000 units to be purchased from outside market @ $12 per unit.

therefore total cost would be $54.45 per part for 7000 units and $60 per part for 3000 units.Selling price of Model 7AC is $58 per unit in market. **($60= $12 Part 4CM purchase cost+ Direct material $23+ Direct Labour $15 + Variable overhead $3.50 + Fixed overhead $6.50)

Thus, total contribution margin of Small AC division - Model 7AC = [(58-54.45)*7000] + [(58-60)*3000] = $18,850

Total Contribution of company (firm wide) = 16,650+ 18,850 = $35,500.

Solution to Que 2.

Minimum Transfer price of Part 4CM =Variable cost per unit = $ 4.65 (because fixed overhead occurs in all situation)

Maximum Transfer Price of Part 4CM = External market Selling Price = $12 per unit ( Next best alternative)