Your firm operates a boutique motel with three operating departments, accommodat
ID: 2353404 • Letter: Y
Question
Your firm operates a boutique motel with three operating departments, accommodation (ACC), food and beverage (F & B), and gift shop (GS). The following issues have arisen and you are required to report to the Board of Management on the matters raised and the explanations requested.
All three operating areas use hand made chocolates produced by F & B. Market purchase price of $5.00 has been used as the transfer price in the past and the following data has been drawn from last years activities. Over the year 50,000 chocolates are produced, 60% are used for functions organised by F & B, 20% by ACC and the balance are sold to external customers through the GS.
F & B’s unit costs are:
Variable costs $3.50
Fixed costs $2.00
Selling price in GS to external customers is $6.00 per unit.
Required:
a) Should the current policy of market transfer price be continued, why? If you disagree, what is your recommendation for the transfer price? (5 marks)
b) What effect, if any, does maximum capacity have on the minimum transfer price? (3 marks)
c) If GS was able to purchase 2,000 units from an outside supplier for $3.00 per unit. The units would have to be packaged before sale which would cost $0.50 per unit. The demand by external customers will not change.
Should the organisation allow GS to purchase the units externally? Why or why not? (5 marks)
d) Suppose that GS has the choice of:
(i) Cutting the selling price for external sales from $6.00 to $4.00 which would guarantee additional sales of 100 units per month of chocolates in GS, or
(ii) Maintain the current position.
Which option should be chosen? (5 marks)
e) What other considerations should management factor into the decision making process in regard to purchasing from external sources or cutting the selling price? (7 marks
Explanation / Answer
a) Should the current policy of market transfer price be continued, why? If you disagree, what is your recommendation for the transfer price?
There may be three criteria to determine a fair Transfer price policy viz.
1. Market based less adjustment for the economies of handling internally.
2. Cost-based i.e. full manufacturing cost of the F&B department
3..Negotiated i.e. a price that is mutually agreed by F&B and ACC & GS departments
In the light of the above, the current policy of selling to ACC & GS departments at $5.00 per chocolate seems to be appropriate in the sense that ACC & GS will prefer to purchase from outside at $5.00 rather than to purchase from F&B at its full manufacturing cost of $5.50($3.50 + $2.00) leaving 40% chocolates (20,000 chocolates) unsold. The transfer-price of $5.00 is also above the marginal cost to F&B department.
b) What effect, if any, does maximum capacity have on the minimum transfer price?
If maximum capacity is less than or equal to 30,000 chocolates i.e. the quantity used by F&B department itself then ACC & GS departments may be asked to purchase from outside.
c) If GS was able to purchase 2,000 units from an outside supplier for $3.00 per unit. The units would have to be packaged before sale which would cost $0.50 per unit. The demand by external customers will not change.
Should the organisation allow GS to purchase the units externally? Why or why not?
The outside supplier cost (after packaging) is equal to the marginal cost of F&B department. In this case GS should not purchase from outside supplier as it will leave 4% i.e. 2000 x 100 / 50,000 unutilized capacity in the F&B department that will increase per unit Fixed cost for F&B department and would reduce departmental profit (ACC department) as well as overall firm's profit.
d) Suppose that GS has the choice of:
(i) Cutting the selling price for external sales from $6.00 to $4.00 which would guarantee additional sales of 100 units per month of chocolates in GS, or
(ii) Maintain the current position.
Which option should be chosen?
Maintain the current position as should be cosen as it would generate $10,000 profit for GS department i.e. 50,000 x 20% x ($6.00 - $5.00) = $10,000 against cutting down selling price to $ 4.00 and purchase from outside supplier i.e. [10,000 + (100x12)] = 11,200 chocolates x ($4.00 - $3.50) and earning profit of $5,600.
e) What other considerations should management factor into the decision making process in regard to purchasing from external sources or cutting the selling price?
Purchasing from external sources
1) Lead time to receive chocolates
2) Quality
3) validity of $3.00 purchase price, wheather long term or short term
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