Tatooine Ltd. has two divisions. The Compound Division makes R2D2, an industrial

Question

Tatooine Ltd. has two divisions. The Compound Division makes R2D2, an industrial compound, which is then transferred to the Processing Division. The Processing Division further processes the R2D2 and sells the final product to customers at $87/kg. Capacity in the Compound Division is 800,000 kg. R2D2 can be obtained on the external market at $50/kg. Data regarding the costs per kilogram in each division are presented below:

*In the Compound Division the variable overhead is 80% of the total, and in Processing variable overhead represents 65% of the total. Fixed overhead rates are based on capacity of 800,000 kg. in each division.
In addition to the manufacturing costs, the Compound Division would incur $2 per kilogram of selling costs which would be avoided on internal transfers. Similarly the Processing Division would avoid $3/kg. of ordering costs on internal purchases.
Required:
1) Calculate the operating incomes for each division assuming 800,000 kg. of R2D2 are transferred and the company uses a market transfer price.
2) Calculate the operating incomes for each division assuming 800,000 kg. of R2D2 are transferred and the company uses a transfer pricing policy based on 125% of absorption manufacturing cost.
3) What are the respective division managers preferences for method of transfer price?
4) Should the company transfer its 800,000 kg. assuming the Compound Division can sell all of its output on the external market?

Column1 Column2 Column3 Column4 Column5 Compound Division Processing Division Direct Material $                  8 $                6 Direct Labour $                12 $              12 Manufacturing overhead* $                28 $              18

Explanation / Answer

a.

Total Operating Profit = 1600000+800000=2400000

b.

First Calculating Transfer Price of R2D2:

Calculating Operating profit:

Total Operating Profit = 9600000 - 7200000 = 2400000

c.

Operating Profit under different method:

For manager of compound division, since operating profit under method '125% of absorption cost' is more by $ 800000, preference will be given to that method.

Conversely, if the market price method is followed, processing division earn operating profit of 800000. However, as per absorption costing method its profit is converted into loss of 7200000. Hence, manager of processing division should give preference to market price method for calculating transfer price for R2D2

d.

Operating Profit, if entire R2D2 is sold to external market:

Total operating profit /(loss) = (1600000)

Compound Division Processing Division Selling Price                               50.00                              87.00 Direct Material                               (8.00)                              (6.00) Direct Material (R2D2)                                      -                              (50.00) Direct Labour                            (12.00)                            (12.00) Variable Mfg. Overhead                            (22.40)                            (11.70) Contribution margin per unit                                 7.60                                7.30 Total Contribution Margin                      60,80,000                      58,40,000 Fixed Mfg. Overhead                    (44,80,000)                   (50,40,000) Net Operating income                      16,00,000                        8,00,000

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