Transfer pricing: internal transfer versus external sale

Household Appliances Ltd is a divisionalised company in which each of the two divisions operates as an independent investment centre. For the coming financial year the pre-tax target rate of return for the divisions and for the company as a whole is 15%.

Division A produces electric motors and plans to sell 60% of its output to Division B for use in the production of tumble clothes dryers, while the remainder are to be sold to an outside user who has contracted to buy 2000 motors. No further outside sales appear possible. Division A is planning to produce 5000 motors (normal capacity).

Variable cost per motor is $30 while fixed production costs of $50 000 are expected in Division A. Division A allocates fixed costs on the basis of normal capacity, regardless of actual production.

The sales price for external sales is $55 per motor. For the purposes of

internal pricing the manager of Division A sets a profit markup of 50% on full absorption cost in order to earn a satisfactory return on divisional assets employed, $500 000.

Division B has in the past purchased all its motors from Division A. Division

B's costs consist of the transfer-in cost, additional variable production costs of

$48 per dryer, and $60 000 fixed production costs which are allocated to dryers on an expected annual production basis. Division B plans to produce

3000 dryers in the coming year. Division B sells the finished dryers to retailers for $180 each. Assets employed in Division B total $1 140 000.

An external supplier has offered to provide two-thirds of Division B's electric motor requirements for the coming year at a price of $45.

Required:

(a) Calculate the expected profit and rate of return on investment for each division and for the company as a whole in the coming year, if Division B purchases its motors from Division A, and sells its entire output to retailers.

(b) Should Division B buy its motors from the external supplier? Why? (c) Prepare divisional and corporate profit and loss statements on an

absorption costing basis on the assumption that Division B accepts the offer from the external supplier and Division A adjusts its planned output accordingly. Calculate the company and divisional rates of return. On the basis of these calculations state whether it would be in the best interests of the company to accept or reject the offer.

(c) Assume the payoff matrix is a cost matrix. What strategy would a pessimist select?