English Allied Traders plc has a wide range of manufacturing activities, principally within the UK. The company operates on the divisionalized basis with each division being responsible for its own manufacturing, sales and marketing, and working capital management. Divisional chief executives are expected to achieve a target 20 per cent return on sales.
A disagreement has arisen between two divisions which operate on adjacent sites. The Office Products Division (OPD) has the opportunity to manufacture a printer using a new linear motor which has recently been developed by the Electric Motor Division (EMD). Currently there is no other source of supply for an equivalent motor in the required quantity of 30 000 units a year, although a foreign manufacturer has offered to supply up to 10 000 units in the coming year at a price of £9 each. EMD's current selling price for the motor is £12. Although EMD's production line for this motor is currently operating at only 50 per cent of its capacity, sales are encouraging and EMD confidently expects to sell 100 000 units in 2013, and its maximum output of 120 000 units in 2014.
EMD has offered to supply OPD's requirements for 2013 at a transfer price equal to the normal selling price, less the variable selling and distribution costs that it would not incur on this internal order. OPD responded by offering an alternative price of the standard variable manufacturing cost plus a 20 per cent profit margin. The two divisions have been unable to agree, so the corporate operations director has suggested a third transfer price equal to the standard full manufacturing cost plus 15 per cent. However, neither divisional chief executive regards such a price as fair.
EMD's 2013 budget for the production and sale of motors, based on its standard costs for the forecast 100 000 units sales, but excluding the possible sales to OPD, is as follows:

The costs of the sales force and indirect production staff are not expected to increase up to the current production capacity.
2 General overhead includes allocations of divisional administrative expenses and corporate charges of £20 000 specifically related to this product.
3 Depreciation for all assets is charged on a straight line basis using a five-year life and no residual value.
4 Carriage is provided by an outside contractor.
(a) Calculate each of the three proposed transfer prices and comment on how each might affect the willingness of EMD's chief executive to engage in inter-divisional trade.
(b) Outline an alternative method of setting transfer prices which you consider to be appropriate for this situation, and explain why it is an improvement on the other proposals.

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(E000) Sales revenue (100 000 units at £12.00 each) Direct manufacturing costs Bought-in materials Labour Packaging 360 230 40 Indirect manufacturing costs Variable overheads Line production managers Depreciation 10 30 Capital equipment Capitalized development costs 150 60 880 Total manufacturing costs Sales and distribution costs Salaries of sales force Carriage General overhead Total costs Profit 50 20 50 1000