Question

The cost of manufacturing the parts is as follows: Based on a practical volume of 200,000 parts:

- RM Direct materials: 20
- Direct Labour: 4
- Variable overhead: 6
- Fixed overhead*: 10
- Total Cost: 40

Other costs incurred by the Mechanical Division are as follows:

- RM Fixed selling and administrative: 500,000
- Variable selling (per unit): 1

The part usually sells for between RM 56 and RM 60 in the external market. Currently, the Mechanical Division is selling it to external customers for RM 58. The division is capable of producing 200,000 units of the part per year; however, because of a weak economy, only 150,000 parts are expected to be sold during the coming year. The variable selling expenses are avoidable if the part is sold internally. The Engineering Division has been buying the same part from an external supplier for RM56. It expects to use 50,000 units of the part during the coming year. The manager of the Engineering Division has offered to buy 50,000 units from the Mechanical Division for RM 36 per unit.

Required:

A. Define transfer price and identify and describe the 5 different transfer pricing methods.
B. Determine the minimum transfer price that the Mechanical Division would accept.
C. Determine the maximum transfer price that the manager of the Engineering Division would pay. Would the Engineering Division manager accept buying at RM58? Why or why not?
D. Should an internal transfer take place? Why or why not? If you were the manager of the Mechanical Division, would you sell the 50,000 components for RM 36 each? Explain.
E. Suppose that the average operating assets of the Mechanical Division total RM 20 million, and assuming that the 50,000 units are transferred to the Engineering Division for RM 42 each:
i. Prepare an income statement for the Mechanical Division and calculate its operating income.
ii. Compute the return on investment (ROI) for the coming year.

Answer 1

The minimum transfer price for the Mechanical Division is RM 30, which covers the variable production costs. The maximum the Engineering Division would theoretically pay is RM 57, making an internal transfer price of RM 58 unattractive. An internal transfer at RM 36 would not be beneficial for the Mechanical Division as it's below their variable production costs.

Step-by-step explanation:

Minimum Transfer Price Calculation

The minimum transfer price for the Mechanical Division would be the sum of the direct materials, direct labor, and variable overheads, which amounts to RM 20 + RM 4 + RM 6 = RM 30 per unit. This price covers the variable costs associated with producing one more unit for the Engineering Division, and therefore, it is the lowest price that the Mechanical Division would accept for an internal transfer.

Maximum Transfer Price Calculation

The maximum transfer price that the manager of the Engineering Division would pay is the current external purchase price, which is RM 56 per unit. Because the variable selling expenses of RM 1 per unit are avoidable if the part is sold internally, theoretically, the Engineering Division could pay up to RM 57 (RM 56 + RM 1 saved). However, at RM 58, the Engineering Division manager would likely decline as it would be more expensive than their current external purchase price.

Internal Transfer Decision

An internal transfer should be considered beneficial if it leads to overall cost savings for the company and doesn't negatively impact the profitability of the selling division. If the Mechanical Division sells at RM 36, which is below the variable cost per unit, it would not cover the full costs of production, leading to a loss on each unit sold internally. Therefore, selling at RM 36 each would not be favorable for the Mechanical Division.

Income Statement and ROI Calculation

To prepare an income statement for the Mechanical Division and calculate its operating income with the transfer price of RM 42, we need to consider total revenues (RM 42 * 50,000), total variable costs, and fixed costs. The ROI would be calculated by taking the operating income and dividing it by the average operating assets. Without complete financial data, we cannot perform these calculations in full.