Question:
Resolving a transfer price convict
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:
|
Product I
|
Product J
|
|
(£)
|
(£)
|
|
Established selling price
|
30
|
50
|
|
Variable costs
|
|
|
|
Direct material
|
8
|
5
|
|
Transfers from A
|
|
30
|
|
Direct labour
|
5
|
3
|
|
Variable overhead
|
2
|
2
|
|
15
|
40
|
|
Divisional fixed cost (per annum)
|
£500000
|
£225000
|
|
Annual outside demand with current selling prices (units)
|
100000
|
25000
|
|
Capacity of plant (units)
|
130000
|
30000
|
|
Investment in division
|
£6625000
|
£1250000
|
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.