The McNabb Company’s Eastern Division has capacity to produce 200,000 widgets an

Question

The McNabb Company’s Eastern Division has capacity to produce 200,000

widgets annually. The normal selling price is $19 per widget. Fixed costs are $800,000,

and variable costs are $7 per widget. Another division of McNabb Company would like

to buy some widgets from the Eastern Division.

Required:

A) Assume the Eastern Division is operating at 100% of capacity (demand from

current customers exceeds the Eastern Division's production capacity). The

Western Division would like to purchase 10,000 widgets from the Eastern

Division, and $2 of the variable costs incurred by the Eastern Division could be

avoided on each widget transferred. What is the lowest transfer price the Eastern

Division should accept?

B) Assume that the Eastern Division is operating at 80% of capacity. The Western

Division would like to purchase 20,000 widgets. No variable cost would be

avoided on the sale. What is the lowest transfer price the Eastern Division should

accept?

C) Assume the Eastern Division is operating at 95% of capacity. The Western

Division would like to buy 40,000 widgets in an all-or-nothing deal (it is 40,000

or zero). There would be no variable cost savings. What is the lowest transfer

price the Eastern Division could accept to maintain its current profitability?

Explanation / Answer

Solution A:

It should be noted that Eastern Division of the company is operating at full capacity. If it has to make a supply to Western division, it will have to forego the contribution earned on regular sales. Currently, Eastern division makes a contribution per unit of $12 [Selling Price ($19) – Variable Cost ($7)].

If Eastern division sells 10,000 widgets to Western division, it will incur a variable cost of $5 ($7 - $2) per widget. In addition, it will forego the contribution of $12 per widget as opportunity cost.

In total, lowest transfer price by Eastern Division is total of variable cost incurred + benefits lost in form of contribution

Lowest Transfer Price per unit= $5+ $12 = $17

Transfer Price = 10,000 * 17 = $170,000

Solution B:

It should be noted that Eastern Division of the company is operating at 80% capacity. If it has to make a supply to Western division till 20% of spare capacity, it will charge a minimum of the variable cost incurred on the widget. The Spare capacity in terms of unit is 40,000 units (200,000 * 20%).

If 20,000 widgets to be supplied to western division, it will not lose any revenue on regular sales.

Hence Minimum Transfer Price= Variable cost incurred

= $7

Lowest Transfer Price per unit= $7

Transfer Price = 20,000 * 7 = $140,000

Solution C:

It should be noted that Eastern Division of the company is operating at 95% capacity. If it has to make a supply to Western division till 5% of spare capacity, it will charge a minimum of the variable cost incurred on the widget. The Spare capacity in terms of unit is 10,000 units (200,000 * 5%).

For First 10,000 units:

Till 10,000 units, Eastern division will charge a minimum transfer price of amount equal to its variable cost. Variable Cost is $7, Hence for first 10,000 units, Transfer Price will be $70,000.

For Next 30,000 units:

For the next 30,000 widgets, it will incur a variable cost of $7 per widget. In addition, it will forego the contribution of $12 per widget as opportunity cost (solution 1).

In total, lowest transfer price by Eastern Division is total of variable cost incurred + benefits lost in form of contribution

Lowest Transfer Price per unit= $7+ $12 = $19

Transfer Price = 30,000 * 19 = $570,000

Total Transfer Price for 40,000 units = $70,000 + $570,000 = $640,000

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