Question

Question 6

Manuco company has been offered supplies of special ingredient Z at a transfer price of GHS15 per kg by Helpco company, which is part of the same group of companies. Helpco produces and sells special ingredient Z to costumers external to the group at GHS15 per kg. Helpco basis its transfer price on on full cost plus 25% profit markup.

The full cost has been estimated at 75% variable and 25% fixed. Internal transfer to Manuco would enable GHS1.50 per kg of variable packing cost to be avoided.

Required:

Discuss the transfer prices at which Helpco should offer to transfer special ingredient Z to Manuco in order that group profit maximizing decisions are taken in each of the following situations:

1. Helpco has an external market for all production of special ingredient Z at a selling price of GHS15 per kg.
2. Helpco has production capacity for 9,000kg of special ingredient Z. an external market is available for 6,000 kgs of material Z.
3. Helpco has production capacity for 3,000 kg of special material Z. an alternative use for some of its spare production capacity exists. This alternative use is equivalent to 1,000kg of special ingredient Z and would earn a contribution of GHS6,000. There is no external demand.

Answer 1

a) If Helpco has an external market for all production of special ingredient Z at a selling price of GHS15 per kg and no spare capacity is available then transfer price will be computed as follows:-

Transfer price = standard variable production cost + contribution forgone by not selling to outsiders

Here,

Standard variable production cost = 75% of full cost – Packing cost GHS1.50

Full cost = transfer price GHS15 – 25% profit markup

                = GHS15 – 25% of GHS15

                = GHS15 – GHS3.75

                = GHS11.25

So, Full Cost is GHS11.25

And

Standard variable production cost = 75% of GHS11.25

                                                                     = GHS8.4375                                

Hence Standard variable production cost is GHS8.4375

Contribution = Market Price - Standard variable production cost

                          = GHS15 – GHS8.4375

                          = GHS6.5625

So, transfer price will be

Transfer price = standard variable production cost + contribution forgone by not selling to outsiders

                                = GHS6.9375 + GHS6.5625

                                = GHS13.5

b) If Helpco has production capacity for 9,000kg of special ingredient Z. an external market is available for 6,000 kgs of material Z, then we will compute Transfer Price in two ways:-

i) Transfer Price for 6,000 kgs of material Z which have outside demand. In such case Transfer Price will be same as computed above i.e. GHS13.5. Hence Transfer Price of 6,000 kgs of material Z is GHS13.5

ii) Transfer Price for 3,000 kgs of material Z which does not have outside demand. In such case Transfer Price will be Standard variable production cost i.e. GHS8.4375

c) If Helpco has production capacity for 3,000 kg of special material Z. an alternative use for some of its spare production capacity exists. This alternative use is equivalent to 1,000kg of special ingredient Z and would earn a contribution of GHS6,000. There is no external demand, then we will compute Transfer Price in two ways:-

i) Transfer Price for 1,000 kgs of material Z which have alternative use. In such case Transfer Price will be computed as below:

Transfer price = standard variable production cost + contribution forgone by not selling to outsiders

= GHS6.9375 + GHS6

                        = GHS12.937

ii) Transfer Price for 2,000 kgs of material Z which does not have outside demand. In such case Transfer Price will be Standard variable production cost i.e. GHS8.4375