A firm consists of two profit centers, Production, and Distribution. Production produces a single computer software product that may be sold on the open market for £200 per unit. The Distribution division adds a step-by-step ‘Teach yourself’ manual to the software and packages them in an attractive box, then sells the package for £240. The teach-yourself guide is an optional extra, as the software already has a basic users’ guide.

The total cost functions of the two divisions are:

Production Division: Cp(q) = 14000 + 40q + 0.1q^2

Distribution Division: Cd(q) = 1200 + 20q + 0.1q^2

The management of the firm wishes to set a transfer price that will induce both divisions to act simultaneously in the best interests of the firm as a whole:

Required:

1. Show that, in order to maximise overall firm profit, the Production division should produce 800 units, 100 of which should be transferred to the Distribution division for further processing.

2. State what transfer price should be set for the Production division’s output. Explain why you would set this price.

3. Prepare summary profit and loss accounts for each division and for the firm as a whole.

4. Should the Distribution division be closed?

5. What are the main limitations of the economic transfer pricing model in practice?

Answer rating: 100% (QA)

The model does not take into account the possibility of different market prices for the same pr... View the full answer