Question - Transfer Pricing

Peter Alexander sells a range of different hand creams. The following presents hypothetical information concerning the production of these hand creams. These hand creams are produced by Fragrance Ltd and shea butter is a key ingredient of the hand creams. The shea butter is produced by the Shea Butter Department who extracts and refines the oil from roasted shea nuts. The shea butter is provided to the Mixing Department who combines the shea butter with the other ingredients. The Shea Butter Department can sell the finished refined shea butter to external customers. The market price is $40.00 per kilogram. The following table summarises the cost to the Shea Butter Department to produce each kilogram of shea butter.

Shea Butter (1 kg)Direct Materials$10.00Direct Labour$5.00Variable Overhead$3.00Fixed Overhead$1.00

Required:

1. The manager of the Mixing Department argues that their department should not have to pay anything for the shea butter they receive internally from the Shea Butter Department. They argue that there is no point because it is an internal transaction and putting a price on the transfers decreases their department's profitability. Discuss whether you agree with this statement.

2. Assuming the transfer price for shea butter sales between the Shea Butter Department and Mixing Department was established through negotiation between managers, identify the likely range of possible transfer prices. Is this method of establishing a transfer price appropriate? What other techniques are available? Overall, which is the most appropriate for this situation and why?

3. Calculate the transfer price for shea butter sales between the Shea Butter Department and the Mixing Department if cost-plus pricing, based on absorption cost with a 30% markup, is used.

4. Illustrate how the application of the general transfer price rule for shea butter sales between the Shea Butter Department and the Mixing Department would result in different prices depending on whether the Shea Butter Department had spare capacity or otherwise.

Ensure that your answers for the above are discussed and supported by relevant calculations/workings.