The Northern Division of the Sherer Group of companies manufacturers one product, product X, which it sells for £500 per unit. Northern Division has budgeted to manufacture and sell 100,000 units of product X in 1993. Unit data for the product is as follows:
Direct labour Component part Other variable costs Fixed overheads Profit Selling price
£
100
150
50
100
100
500
The component part used in the manufacture of product X is supplied to Northern Division by another division of the Sherer Group, Southern Division. The cost of £150 for the component part represents the transfer price from Southern Division to Northern Division. The transfer price of £150 is calculated, on a full cost-plus basis, by Southern Division as follows:
Variable costs: £
Direct labour 20
Direct material 60
Expenses 20
Fixed overheads 20
Profit 30
150
Southern Division produces other components as well as the type transferred to Northern Division. However, it does have sufficient capacity to meet all of Northern's requirements and even after meeting their requirements, it will still be working with spare capacity. If the component is not produced at Southern, there is no opportunity for further work to replace it.
Sherer Group has set a target of 25% return on investment (ROI) and Northern Division and the managers of Northern Division will only receive an annual bonus if this figure is achieved. The capital employed of Northern Division in 1993 is £50m. The General Manager of Northern Division realizes that the budgeted ROI does not meet the group's requirements. As a result of this, the General Manager has been looking at ways of improving the profitability of his division. One of the options being considered is the purchase of the component part used in product X from an external supplier. Robo pk, a company which is not part of the Sherer Group, can supply the component part to Northern Division at a price of £125 each.You are required to:
(a) Calculate the effect of purchasing the component from Robo pie on Northern Division's profits and comment on the likely reaction of the General Manager of Northern Division to this option.
(b) Calculate the effect of the purchase of the component from Robo pie on the group's overall profits and comment on the likely reaction of the Group management team.
(c) Critically evaluate the method of transfer pricing being used in the Sherer Group.