- 20 Marks
Question
Adeb Nigeria Limited has two divisions, Eastern and Northern divisions. Eastern division makes materials that are used to manufacture special blocks. It transfers some of these materials to the Northern division and sells some of the materials externally to other block manufacturers. Northern division makes special blocks from the materials and sells them to traders in building materials.
The production capacity of Eastern division is 10,000 tonnes per month. At present, sales are limited to 5,000 tonnes to external customers and 3,000 tonnes to Northern division.
The transfer price was agreed at ₦200 per tonne in line with the external sales trade price at 1st July which was the beginning of the budget year. From 1st December, however, strong competition in the market has reduced the market price for the materials to ₦180 per tonne.
The manager of the Northern division has suggested that the transfer price for the materials from Eastern division should be the same as for external customers. The manager of Eastern division rejected this suggestion on the basis that the original budget established the transfer price for the entire financial year.
From each tonne of materials, Northern division produces 10 blocks, which it sells at ₦40 per block. It would sell a further 20,000 blocks if the price were reduced to ₦32 per block.
Other relevant data are given below:
| Division | Eastern | Northern |
|---|---|---|
| Variable cost per tonne | ₦70 | ₦60 |
| Fixed cost per month | ₦150,000 | ₦60,000 |
The variable costs of Northern division exclude the transfer price of materials from Eastern division.
Required:
a. Prepare estimated profit statements for the month of December for each division and for Adeb Nigeria Limited as a whole, based on transfer prices of ₦200 per tonne and ₦180 per tonne, when producing at:
i. 80% capacity
ii. 100% capacity, assuming Northern division reduces the selling price to ₦32. (10 Marks)
b. Comment on the effect that might result from a change in the transfer price from ₦200 to ₦180. (5 Marks)
c. Suggest an alternative transfer price that would provide an incentive for Northern division to reduce the selling price and increase sales by 20,000 blocks a month. (5 Marks)
Answer
ADEB NIGERIA LIMITED
(a) Profit statements in December
(i) Operating at 80% capacity
(ii) Operating at 100% capacity
N/B: Under the Northern Div. External Sales = ((₦32x5000x10 blocks) = ₦1,600,000
Under the Northern Div. Variable Costs = ((₦60×5000) = ₦300,000
(b) The effect of a change in the transfer price from ₦200 to ₦180 will result in
lower profit for Eastern division and higher profit for Northern division, but
the total profit for the company as a whole will be unaffected.
A reduction in the transfer price to ₦180 (or possibly lower) is recommended,
because this is the price at which Northern division can buy the materials
externally. At any price above ₦180, Northern division will want to buy
externally, and this would not be in the interests of the company as a whole.
Significantly, at a transfer price of both ₦200 and ₦180, Northern division
would suffer a fall in its divisional profit if it reduced the selling price of
blocks to ₦32 and increased capacity by 20,000 blocks each month. A
reduction in price would be in the best interests of the company as a whole,
because total profit would rise from ₦1,150,000 per month to ₦1,290,000.
(c) Ignoring the transfer price, the effect on Northern division of reducing the sale
price of blocks to ₦32 would be to increase external sales by ₦640,000 and
variable costs in Northern division by ₦120,000 (2,000 tonnes ₦60). Cash
flows would therefore improve by ₦520,000 per month (₦640,000 less
₦120,000). To persuade Northern division to take the extra 2,000 tonnes, the
transfer price should not exceed ₦260 (₦520,000/2,000). This is above the
current external market price which is ₦180 although there is strong price
competition in the market
The transfer price for Eastern division should not be less than the variable cost
of production in Eastern division, which is ₦70 per tonne.
In the final analysis, an optimal transfer price suggested should be between
₦70 to ₦180.
- Level: Level 2
- Topic: Divisional Performance Measurement, Pricing Decisions
- Series: NOV 2020
- Uploader: Kwame Aikins