Ludmilla Corp. has two divisions: Engine and Mobile Systems. The Engine Division produces engines used by both the Mobile Systems Division and a variety of external industrial customers. External sales orders are generally produced in 50-unit lots. Using this typical lot size, the cost per engine is as follows:
Variable production cost ....... $4,200
Fixed manufacturing overhead ...... 1,800
Variable selling expense ....... 600
Fixed selling expense ........ 840
Fixed administrative expense ..... 1,280
Total unit cost ........... $8,720
An engine's external selling price is $10,464, providing the Engine Division with a normal profit margin of 20 percent. Because a significant number of sales are being made internally, Engine Division managers have decided that the external selling price should be used to transfer all engines to Mobile Systems.
When the Mobile Systems Division manager learned of the new transfer price, she became very upset because it would have a major negative impact on her division's profit. Mobile Systems has asked for a lower transfer price from the Engine Division so that it earns a profit margin of only 15 percent. Mobile Systems' manager has asked corporate management whether the division can buy engines externally. Faye Ryan, Ludmilla's president, has gathered the following information on transfer prices to help the two divisional managers negotiate an equitable transfer price:
Current external sales price .....................$10,464
Total variable production cost plus a 20% profit margin ($4,200 x 1.2) .... 5,040
Total production cost plus a 20% profit margin ($6,000 x 1.2) ......... 7,200
Bid price from external supplier (if motors are purchased in 50-unit lots) .... 9,280
a. Discuss advantages and disadvantages of each of these transfer prices to both the selling and buying divisions and to Ludmilla Corp.
b. If the Engine Division could sell all of its production externally at $10,464, what is the appropriate transfer price and why?