Question 4c
A manufacturing company, Man Co, has two divisions: Division L and Division M. Both divisions make a single standardised product. Division L makes component L, which is supplied to both Division M and external customers.
Division M makes product M using one unit of component L and other materials. It then sells the completed product M to external customers. To date, Division M has always bought component L from Division L.
The following information is available:
| Component L | Product M | |
|---|---|---|
| $ | $ | |
| Selling price | 40 | 96 |
| Direct materials: | ||
| Component L | (40) | |
| Other | (12) | (17) |
| Direct labour | (6) | (9) |
| Variable overheads | (2) | (3) |
| Selling and distribution costs | (4) | (1) |
| Contribution per unit before fixed costs | 16 | 26 |
| Annual fixed costs | $500,000 | $200,000 |
| Annual external demand (units) | 160,000 | 120,000 |
| Capacity of plant | 300,000 | 130,000 |
Division L charges the same price for component L to both Division M and external customers. However, it does not incur the selling and distribution costs when transferring internally.
Division M has just been approached by a new supplier who has offered to supply it with component L for $37 per unit. Prior to this offer, the cheapest price which Division M could have bought component L for from outside the group was $42 per unit.
It is head office policy to let the divisions operate autonomously without interference at all.
Required:
(c) Discuss the problems which will arise if the transfer price remains unchanged and advise the divisions on a suitable alternative transfer price for component L. (6 marks)