Division R makes watzits. The company has sufficient capacity to make 70,000 wat

Question

Division R makes watzits. The company has sufficient capacity to make 70,000 watzits per year. The company expects to sell 65,000 watzits this year. Division S uses watzits in their production and has total needs of 20,000 watzits this year. Division S is currently buying watzits from an outside supplier for $11.25 each. The cost to Division R to make the watzits are $5.00 for direct materials, $2.00 for direct labor, $2.50 for variable manufacturing overhead, and $1.50 for fixed manufacturing overhead. Direct labor is a variable cost. Division R sells watzits on the outside market for $11.50 each.

Assuming that Division S buys its entire 20,000 requirement of watzits from Division R, is it possible for Division R and Division S to agree to a mutually acceptable transfer price and if so, within what range would that transfer price be?

Division A makes watzits. The company has sufficient capacity to make 70,000 watzits per year. The company expects to sell 65,000 watzits this year. Division B uses watzits in their production and has total needs of 20,000 watzits this year. Division B is currently buying watzits from an outside supplier for $11.25 each. The cost to Division A to make the watzits are $5.00 for direct materials, $2.00 for direct labor, $2.50 for variable manufacturing overhead, and $1.50 for fixed manufacturing overhead. Direct labor is a variable cost. Division A sells watzits on the outside market for $11.50 each Assuming that Division B buys its entire 20,000 requirement of watzits from Division A, is it possible for Division A and Division B to agree to a mutually acceptable transfer price and if so, within what range would that transfer price be?

Explanation / Answer

Division R has idle capacity of 5000 watzits. If there were no idle capacity then the market price of watzits would be the required transfer price. Since it has only 5000 worth of idle capacity and Division S needs 20000 watzits, Division R will have to forego sales of these 15000 units.

Total Contribution Margin on lost sales = Sales - Variable cost = $11.5 * 15000 - $9.5* 15000 = $30000

Transfer price = Variable cost + (Total contribution margin on lost sales/ Number of units transferred)

= $9.5 + $30000/20000 = $11

Division R would find $11 an agreeable minimum price

Division S buys from an outside supplier for $11.25 each so it will not pay more than that to Division R

The range of transfer price is thus $11 <Transfer Price < $11.25

Division R and Division S can easily come to a mutually acceptable transfer price.

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