Allentown Division of Sparks Incorporated transfers its product to the Youngstown Division. The Youngstown Division can either buy the item internally or externally. The cost of purchasing the item externally is $73 per unit. The Allentown Division has just completed its annual cost update as follows: Direct materials$25.00 Direct labor 18.00 Variable manufacturing overhead 6.00 Fixed manufacturing overhead 3.50 Variable selling expenses 4.00 Fixed selling and administrative expenses 8.50 Total costs$65.00 Desired return 14.00 Sales price$79.00 The Allentown Division is operating at 60 percent of its 400,000 unit capacity.Required:a) What is the minimum transfer price the Allentown Division should charge for internal transfers?b) What is the maximum price the Youngstown

Question

Division would be willing to pay?c) Why should the Allentown Division reduce its price to the Youngstown Division?

What will be an ideal response?

Answer 1

a)
The minimum transfer price should be $53 per unit, which is the outlay cost plus opportunity cost.  Because there is excess capacity, the opportunity cost is zero.  Outlay cost = total variable cost = ($25 + $18 + $6 + $4) = $53 per unit.
b)
The maximum transfer price Youngstown would be willing to pay is the market price of $73 per unit.
c)
The Allentown Division should reduce its price because it has excess capacity. Under the general rule, even though it doesn't work well with excess capacity, only costs incurred because of production necessitated by the internal transfer should be considered.  Therefore, only variable costs should make up the transfer price. The price also does not reflect that actual fixed cost per unit will decrease as more units are produced and, with an internal sale, variable selling expense might be eliminated or, at least, reduced.