Question

Avery Company has two divisions, Polk and Bishop. Polk produces an item that Bishop could use in its production. Bishop currently is purchasing 26,000 units from an outside supplier for $16 per unit. Polk is currently operating at less than its full capacity of 630,000 units and has variable costs of $9 per unit. The full cost to manufacture the unit is $12. Polk currently sells 460,000 units at a selling price of $18 per unit.
a. What will be the effect on Avery Company’s operating profit if the transfer is made internally?
b. What is the minimum transfer price from Polk’s perspective?
c. What is the maximum transfer price from Bishop’s perspective?

Answer 1

Answer:

a. The effect is that Avery Company’s operating profit will increase by $182,000 if the transfer is made internally.

b. Minimum transfer price = $9

c. Maximum transfer price from Bishop’s perspective = $16.

Explanation:

a. What will be the effect on Avery Company’s operating profit if the transfer is made internally?

To determine this, fixed cost is ignored because it considered irrelevant. Therefore, we have:

Profit per unit = Purchase price from outside - Variable cost of production internally = $16 - $9 = $7

Total increment in operating profit = Current purchase unit of Bishop * Profit per unit = 26,000 * $7 = $182,000

Therefore, Avery Company’s operating profit will increase by $182,000 if the transfer is made internally.

b. What is the minimum transfer price from Polk’s perspective?

Since Polk is currently operating at less than its full capacity, this implies that it will not incur additional fixed cost to produce current purchase units of Bishop. Therefore, only its variable cost of $9 will have to recovered. By implication, we have:

Minimum transfer price = Variable cost = $9

c. What is the maximum transfer price from Bishop’s perspective?

Any price that is higher than $16 at which Bishop is currently purchasing from an outside supplier will result in a loss for Bishop and the increment profit of $182,000 will be lost by Avery Company. This therefore implies that:

Maximum transfer price from Bishop’s perspective = Price at which Bishop is currently purchasing from an outside supplier = $16