A manufacturing company, Man Co., has two divisions: Division L and Division M. Both divisions make a single standardized product. Division L makes component L, which is supplied to both Division M and external customers. Division M makes product M using one unit of component L and other materials. It then sells the completed product M to external customers. To date, Division M has always bought component L from Division L.
The following information is available:

Division L charges the same price for component L to both Division M and external customers. However, it does not incur the selling and distribution costs when transferring internally.
Division M has just been approached by a new supplier who has offered to supply it with component L for $37 per unit. Prior to this offer, the cheapest price which Division M could have bought component L for from outside the group was $42 per unit.

It is head office policy to let the divisions operate autonomously without interference at all.

Required:
(a) Calculate the incremental profit/(loss) per component for the group if Division M accepts the new supplier’s offer and recommend how many components Division L should sell to Division M if group profits are to be maximized.
(b) Using the quantities calculated in (a) and the current transfer price, calculate the total annual profits of each division and the group as a whole.
(c) Discuss the problems which will arise if the transfer price remains unchanged and advise the divisions on a suitable alternative transfer price for component L.

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Selling price Direct materials: Component L Other Direct labour Variable overheads Selling and distribution costs Contribution per unit before fixed costs Annual fixed costs Annual external demand (units) Capacity of plant Component L Product M ($) 40 (12) (6) (2) (4) 16 96 (40) (17) (9) (3) E 26 $500,000 $200,000 160,000 120,000 300,000 130,000