This question covered transfer pricing and, as has been noted in previous diets where this topic has been examined, this was poorly answered. As always, it was important to read the scenario and requirements carefully.

The scenario stated that Division M had the capacity to produce 60,000 motors but total demand was 30,000 motors from external customers and 35,000 from Division S. Therefore, there were 5,000 more motors demanded than Division M could supply.

Currently, it had no choice and had to supply internally before it could make external sales. However, the question was: if this policy could be changed, in order to maximise group profits, should Division M actually sell externally first and let Division S buy 5,000 motors from outside the group.

The first problem with answers came from a lack of reading of the requirement. Many candidates said that Division M must supply Division S first because that was the group policy.

Consequently, they made it impossible to earn any of the marks available for discussing what the optimum internal/external supply combination would be.

It is essential to read requirements carefully; the words ‘assuming the group’s policy could be changed’ were right at the beginning of the requirement to draw candidates’ attention to them.

For those candidates who did interpret the scenario and requirements correctly, only a minority adopted the correct approach in working out the optimum external/internal supply level.

To answer the question it was necessary to compare the incremental cost of buying in for Division S of $60 ($800 external price less $740 internal variable cost) with the incremental loss of $80 in lost contribution if external sales were not made by Division M ($850 price less $770 variable cost of external sales).

Comparing these two figures, it would be better for Division M to sell the 5,000 that were in question to external customers and for Division S to buy 5,000 units in.

The second problem was that candidates did not answer both parts of the requirement as, not only was it necessary to establish the supply levels but it was also necessary to discuss the transfer price/s.

The way to tackle these types of transfer pricing questions is to logically consider the minimum transfer price, the maximum transfer price, then discuss what a reasonable transfer price would therefore be.

This approach is guaranteed to earn marks even if minor errors are made. When answers did adopt this approach, many of them did identify that the transfer price should be between $740 and $800:
the variable cost of producing one motor internally vs the cost of buying one in. However, many answers used $770 as the variable cost of making rather than $740; the $770 was the variable cost of supplying motors externally not internally.