P Ltd has two divisions, Q and R that operate as profit centres. Division Q has recently been set up to provide a component (Comp1) which division R uses to produce its product (ProdX). Prior to division Q being established, division R purchased the component on the external market at a price of £160 per unit. Division Q has an external market for Comp1 and also transfers to division R. Division R uses one unit of Comp1 to produce ProdX which is sold externally. There are no other products produced and sold by the divisions.

Costs associated with the production of Comp1 and ProdX are as follows:

Required

1 State, with reasons, the volume of Comp1 which division Q would choose to produce in the first year and calculate the marginal cost per unit of Comp1 at this volume.
2 a Explain the criteria an effective system of transfer pricing should satisfy.
b Discuss one context in which a transfer price based on marginal cost would be appropriate and describe any issues that may arise from such a transfer-pricing policy.
c Identify the minimum transfer price that division Q would wish to charge and the maximum transfer price which division R would want to pay for the Comp1. Discuss the implications for the divisions and for the group as a whole of the transfer prices that you have identified.

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Fixed costs Variable costs Direct labour Materials Variable overheads Comp1 ProdX 50 000 per annum 100 000 per annum 250 per unit* 15 per hour 25 per unit 3 per labour-hour * The variable cost for ProdX excludes the cost of the component. The first unit of Comp1 will take 20 labour-hours to produce. However, it is known that the work of direct labour is subject to a 90% learning curve. The forecast external annual sales and capacity levels for the divisions are as follows: External sales Division Q Division R Comp1 ProdX Production capacity Division Q Division R Comp1 ProdX 5000 units at a price of 150 per unit 10 000 units at a price of 500 per unit 13 000 units 15 000 units