There are two key divisions in a major international organisation. Division Y makes the small component and Division Z makes the finished product, which incorporates one small component. Division Z normally purchases the small component from Division Y.
Details of the selling prices and costs for each product are:
£ Finished product
Selling Price 66 106
Direct materials 19 10
Transfer price from Y - 66
Direct labour @ £2 per hour 10 6
Variable overhead 5 4
Divisional Fixed Overheads £950,000 £490,000
Outside sales (units) 100,000 25,000
Divisional investment £13,600,000 £2,550,000
Division Z currently has a return on investment below the head office target of 15%. The transfer price of the small component is set at a competitive market price of £66.
After receiving an appeal from the Manager of Division Z to intervene, the Chief Executive asks you to consider a proposal for a 'two-part tariff' transfer price system.
You are required to:
a) Advise the Chief Executive on the appropriateness of the present transfer price system, with supporting calculations of its effects on the respective profitability and returns of each division.
b) To recommend a basis for the two-part tariff transfer price system, with supporting calculations and comment on its impact on the two divisions.
c) Comment on why you think the Chief Executive may be reluctant to intervene.