Question

Magenta Company has a Components Division which currently manufactures 120,000 units of Part AAM but has a capacity to produce 180,000 units. The unit variable cost of Part AAM is $22, and the total fixed costs are $720,000 or $6 per unit based on current production.

As its sales have been down in the current year, Jasper, the manager of the Components Division approached Kelvin, the manager of the Production Division to buy some of its excess capacity. Jasper wants to charge the Production Division at a market price otherwise his profits will fall from last year’s levels. He told Kelvin that the divisions are under strict orders to maximise profitability.

Kelvin asked for a price break saying that both divisions are part of the same company and thus should help each other. He offers to buy 40,000 units of Part AAM at $21 per unit from the Components Division. It has the option to buy from an external supplier for $26 per unit. Jasper refuses to budge as the market price is $26 per unit.

Kelvin then argues that the order should be accepted as Jasper can lower his fixed costs per unit from $6 to $4.50 due to the increase in output. This decrease of $1.50 in fixed costs per unit will more than offset the $1 difference between the unit variable cost and the transfer price.

*Be specific, show workings to justify your answers*

(a) If you were the Components Division manager, would you accept the Production Division manager’s argument? Why or why not? Assume that these 120,000 units currently being produced, sell for $28 per unit in the external market.

(b) Determine the minimum and maximum transfer price. Should an internal transfer take place? Why or why not?

(c) Determine the impact on the profit of each division and the company if an internal transfer takes place.

(d) Explain whether both managers are justified in their arguments. How can the Components Division manager be persuaded to do the internal transfer?

Answer 1

a.
Arguments of Kelvin
- Lower of Fixed Cost from 6 to 4.50 = 1.50
The difference of 1.5 will offset the difference of Varaible cost 22 and Transfer price 21= 1 $
	Component	Transfer to Kelvin as per his terms	Component Result , if Accepted Kelvin Terms
Sale Price	3360000	840000
Variable Cost	2640000	880000
Contribution Margin	720000	-40000	680000
Fixed Cost	720000	0	720000
Net Loss	0	-40000	-40000
With the Acceptance of the terms of the Kelvin the Fixed cost will get distributed, but the loss of 1$ per unit of sale will not be justified as it cause saving of 1.5$ per unit due to acceptance of offer.
hence, It is advisable not to accept the Kelvin Argument .
b.	Minimum Transfer
	From Components View it will that much that will able to cover the Variable Cost of the Producion of the Units Manufactured.
	I.e Minimum TP is 22 $ per Unit
	Maximum Transfer Price: Contribution Lost + Variable Cost per Unit
	Hence Contribution Lost = 6 $
	Variable Cost = 22 $
	Hence, Maximum TP is 6 $ + 22 $ = 28
	with this terms of Kelvin the Internal transfere is not wish to be happen.
c.	If Internal Transfer take Place
	Component Division	Production Division	Company as as Whole
Sale Price	3360000	840000	4200000
Less: variable Cost	2640000	880000	3520000
Contribution	720000	-40000	680000
Less: Fixed Cost	720000	0	720000
Net Profit	0	-40000	-40000
d.	Here, the Justifcation by Jasper that At least 26$
	Because with this he will be able to cover at least Variale cost over per unit.
	whereas , Kelvin argument is baseless and not appropriate.
	Here, Component Managers is justifed with his action of having Internal Transfer with market rate of 26$ in order tor transfer to Production Department .