Question 1 - Airflow Ltd is a manufacturer of air filters. It is currently developing a new model of air filter, Model A2. Market research has been conducted and suggests a price around 20% more than their existing Model A1's price of $200.

The current estimated unit costs of Model A2 are as follows:

Direct material cost $58

Direct labour cost $30

Variable manufacturing overhead cost $20

Fixed manufacturing overhead cost ?

The other operating and administration overhead costs are estimated at 25% of the total manufacturing costs.

Required:

(a) Determine the unit target costs of the air filter, Model A2, if the target operating income is based on 15% return on sales.

(b) If the current estimated full unit cost of Model A2 meets the targeted cost, determine:

(i) the estimated manufacturing cost per unit;

(ii) the estimated fixed manufacturing overhead cost per unit; and

(iii) the estimated other operating and administration overhead costs per unit.

(c) There was news that a new competitor will be marketing a similar air filter at a unit selling price of $220. Airflow decided to reduce the selling price of Model A2 to $218 in order to be competitive. If the company would like to maintain the same dollar amount of operating income as computed in 1(a) above:

(i) Calculate the revised unit target costs;

(ii) Calculate the amount of unit cost reduction required to meet this revised target costs per unit; and

(iii) Suggest any two components of the costs to be reduced, how it should be reduced and by how much.

(d) Airflow Ltd actually sold 2,000 units of Model A2 after the product was launched in the market. Total sales revenue of $436,000 was attained with total full costs incurred at $380,000. Did the company achieve the targeted costs as computed in (c)(i).

(e) The general manager of Airflow Ltd tells you that he prefers the cost-plus pricing method than the more complicated target costing approach, as he has to continually find ways to reduce costs to meet the target costs. As a management accountant, discuss any two of each of the merits and demerits of the cost-plus pricing and target costing approaches.

Question 2 - Ralph Ltd has two profit centres, Dilon and Erbin Divisions. Dilon Division currently produces and sells 50,000 units of output per year, operating at full capacity. The company has an internal transfer pricing arrangement where Dilon Division transfers 80% of its total output to Erbin Division at full cost. The remainder will be sold to external customers at market price of $9 per unit.

Erbin Division uses the materials transferred from Dilon Division to manufacture its product that will be sold to external customers for $22 per unit.

Dilon Division's costs are:

Variable costs $5 per unit

Fixed costs $50,000 per annum

Erbin Division's costs are:

Materials transferred from Dilon Division $6 per unit

Other variable costs of production $12 per unit

Fixed costs $70,000 per annum

The CEO of Ralph Ltd recently realized that the current transfer pricing policy was not appropriate as it results in divisional managers making decisions that are not to the benefit of the company.

Required:

(a) Calculate the profits for each of the two divisions, Dilon and Erbin, and the total of the two under the current transfer pricing policy.

(b) If the CEO abolished the current transfer pricing policy and gives the divisions autonomy in setting the transfer price, what will be the maximum and minimum transfer price?

(c) Set the new transfer price as the average of the maximum and minimum transfer price in 3(b). How will it affect Erbin Division? Compare the Erbin's Division full cost per unit before and after the change in the transfer pricing policy. What course of action will the manager of Erbin Division take?

(d) If Erbin Division is able to find an external supplier for the materials at $8 per unit and Dilon Division refuses to reduce the transfer price but is unable to increase its external sales demand, what will be the effect on the profitability on each of the divisions and the company as a whole?

(e) Given your answers to requirements in 3(d), and there is excess capacity in Dilon Division, advise what is the range of acceptable transfer price that can be negotiated between the two managers. Include in your answers an explanation of opportunity costs that relates to transfer pricing.