Question

ABC Unicycle makes unicycles and has two divisions. Each division is evaluated as a profit center.

The Wheel division, located in Nambia, produces unicycle wheels and can choose to sell wheels on either the open market at $30 per wheel, or sell them to the Assembly division.

The Assembly division, located in Elbonia, assembles unicycles and can choose to either buy wheels from the Wheel division or purchase wheels on the open market.

            Wheel            Assembly

Cost per unit                                                 Division          Division

Direct Labour                                                $2.00               $6.00

Variable Materials                                         3.00                   7.00

Variable Overhead Costs                              4.00                   8.00

Fixed Overhead Costs*                                 5.00                   9.00

Other information

Maximum capacity                                        2,000              3,000

Current production volume                         1,800              2,600

Income tax rate                                             30%              10%

(Fixed overhead costs are based on current production volumes)

The Assembly division would like to purchase an additional 400 wheels from the Wheel division.

Required:

1. What is the likely range of transfer prices between the Wheel Division and Assembly Division?

2. What transfer price would the Head Office prefer for the additional sale of 400 wheels?
3. What are the benefits and drawbacks if the head office chooses the transfer price?

4. What are the pros and cons to the Wheel Division, Assembly Division if the Wheel division is change from a profit centre to a cost centre?
   

Answer 1

ANSWER TO (A)

The Likely range of transfer prices between the Wheel Division and Assembly Division will be $ 30 being the variable cost of producing the Wheel division and the contribution lost by the Wheel Division from selling the Additional 400 wheels to assembly division :

PARTICULARS	AMOUNT ($)
SALES	30.00
LESS : DIRECT LABOUR	2.00
LESS : VARIABLE MATERIAL	3.00
LESS : VARIABLE OVERHEAD COSTS	4.00
CONTRIBUTION PER UNIT	21.00

The Transfer price to be accepted by Wheel Division is the variable cost for producing unicycle wheel and the contribution Wheel Division will loose due to transfer to internal Division = $ 30.00 ( $21 +9 )

The Open Market Price of Unicycle wheel is $ 30.00. Hence the lower Limit and Upper limit of the transfer price is $ 30.00

ANSWER TO (B)

The Transfer Price that Head Office prefers for the additional sale of 400 Wheels is the Marginal cost incurred for producing the Unicycle wheel and a fixed overhead cost

   ANSWER TO (C)

Benefits & Drawbacks of Transfer Price :

• Decisions are made quickly and cost efficiently
• Top managers have time to concentrate on core activities and do not get distracted by routine works
• motivation of managers increases
• Better training for Managers for Higher Level positions in Future

Drawbacks :

• Lack of Co ordination among managers
• Increased cost of obtaining information
• Lack of Goal Congruence among managers

ANSWER TO (C)

PROS & CONS DUE TO CHANGE FROM A PROFIT CENTRE TO COST CENTRE :

• Due to the change from Profit centers to cost centers the cost spend on each activity is known and also helps in controlling or reducing the cost of the business
• Cost centers  help in earning profit indirectly
• Cost centers are responsible for long term survival of the business