Question

Gladwell PLC is a large manufacturing company with divisional performance assessed on the basis of profitability. Division North of this company produces a single product. Although there is an external market for this product, currently 100% of the output is transferred within the company to Division South which incorporates this product into another product which is sold externally. Both divisions are currently operating significantly below full capacity. Division North's Costs per unit of product are (based on current total output): £s Direct Materials 500 Direct Labour 500 Manufacturing Overhead 1,700 Total Cost 2,700 Manufacturing overhead includes a fixed element absorbed at a rate of 100% of direct labour cost with the remaining part being variable overhead. Division North's transfer price for sales to South is £2,800 per unit. To produce the final product, Division South incurs further direct costs of £700 per unit and overhead of £1,000 per unit (50% of this figure is the fixed overhead per unit at current output level and the remainder is variable overhead). Division South's management want to review the transfer price. Both divisions are concerned with maximising profits and Division South argues that a transfer price of £2,300 would be good for total profits of the company. Estimated demand for the final product produced by Division South is shown below: Division South Price Demand (units) £5,000 1,600 £6,000 850 £7,500 400 Required: i. Calculate the contribution of both divisions and of the company overall both in the current situation and using the new transfer price proposed by Division South ii. Is the total profit for the company changed with the new transfer price? Explain the problem being caused by the transfer pricing system in this specific situation. Briefly discuss whether it is advisable for central management to act to reduce such problems arising from transfer pricing systems.

Answer 1

Part (i)

Contribution = Selling price less varible cost

Hence we do not take fixed cost into calculation

Calculation contribution of Both Divisions and Company as a whole using current transfer price of 2800
NORTH DIVISION
Transfer price	2800
Less:Variable cost of production
1. Direct Material	500
2. Direct Labour	500
3.Variable manufacturing overhead(Note-1)	1200
CONTRIBUTION PER UNIT	600
SOUTH DIVISION
Demand in units	1600	850	400
Selling price	5000	6000	7500
Less:Variable cost and transfer price
1.Transfer price	2800	2800	2800
2. Further direct cost	700	700	700
3. Overhead cost (Variable )(Note 2)	500	500	500
CONTRIBUTION PER UNIT	1000	2000	3500
Overall contribution of the company
Selling price	5000	6000	7500
Less:Variable cost and transfer price
1.variable cost of North division	2200	2200	2200
2. Further direct cost	700	700	700
3. Overhead cost (Variable )(Note 2)	500	500	500
CONTRIBUTION PER UNIT	1600	2600	4100

Note -1
Calculation of variable overhead cost of North division
Total over head cost	1700
Less:Fixed overhead cost
which is 100% of direct labour)         500x 100% =500	500
Varible overhead cost	1200
Note -2
Calculation of variable overhead cost of South division
Total over head cost	1000
Less:Fixed overhead cost
which is 50% of total 1000	500
Varible overhead cost	500

Total profit of the company
Contribution per unit	1600	2600	4100
Less:Fixed cost of both North and South Division
North             500
South            500
Total            1000	1000	1000	1000
Profit	600	1600	3100

Calculation contribution of Both Divisions and Company as a whole using proposed transfer price of 2300
NORTH DIVISION
Transfer price	2300
Less:Variable cost of production
1. Direct Material	500
2. Direct Labour	500
3.Variable manufacturing overhead(Note-1)	1200
CONTRIBUTION PER UNIT	100
SOUTH DIVISION
Demand in units	1600	850	400
Selling price	5000	6000	7500
Less:Variable cost and transfer price
1.Transfer price	2300	2300	2300
2. Further direct cost	700	700	700
3. Overhead cost (Variable )(Note 2)	500	500	500
CONTRIBUTION PER UNIT	1500	2500	4000
Overall contribution of the company
Selling price	5000	6000	7500
Less:Variable cost and transfer price
1.variable cost of North division	2200	2200	2200
2. Further direct cost	700	700	700
3. Overhead cost (Variable )(Note 2)	500	500	500
CONTRIBUTION PER UNIT	1600	2600	4100

Total profit of the company
Contribution per unit	1600	2600	4100
Less:Fixed cost of both North and South Division
North             500
South            500
Total            1000	1000	1000	1000
Profit	600	1600	3100

Part (ii)

No,when we take overall profit of the company ,Profit did not changed due to the proposed transfer price.This is because we avoid interdivisional profits when caculating profit of the company as whole.Interdivisional profit or loss does not have any impact on company profit,it will offset while preparing consolidated profit financial statement.

Part (iii)

Yes, A good transfer price should eliminate goal conflicts in each division.A minimum transfer price is the varible cost of North division,but inorder to motivate the north division it is better to add some nominal profit along with variable cost.Minimum=2200 (Variable cost of North Division)