Question 2

Dave Ltd (Dave) has four manufacturing divisions, each of which produces a component that forms part of the final product, which is then sold to external customers. The intermediate products have no external market.

Each component of the final product has a standard "stock" name.

Devon division manufactures component 1 that is sold to Somerset division to be incorporated into component 2.

Somerset division sells component 2 to Dorset division to be used in component 3.

Dorset division sells component 3 to Derbyshire division for 375 per unit. Derbyshire division incorporates component 3 into the final product, which is then sold to Daves external customers.

A unit of component 3 uses one unit of component 2, and a unit of component 2 uses one unit of component 1. As there is no external market for the intermediate products, Devon and Somerset divisions will only produce the quantity of components required by Dorset division.

Standard costs and other data relating to the three components for the year to 31st December 2021 are below: Component 1		Component 2		Component 3
Standard volume (units)	23,600		23,600		23,600
Stocks and work in progress (average)	401,200		536,900		318,600
Fixed assets (net)	542,800		289,100		625,400
Standard cost per unit
Fixed overhead per unit	35.40		22.42		27.14
Material purchased from outside	36.58		27.14		21.24
Direct Labour	49.56		21.24		36.58
Variable overhead	18.88		16.52		12.98

You are the management accountant of Dorset division, reporting to the divisional manager who is required to maximise divisional profits.

Ignore taxation.

Required

a) Prepare an Income Statement forecast for Dorset division for the year ending 31st December 2021 on the basis of 85% of standard volume under each of the following alternative rules for the inter-divisional transfer pricing of components 1 and 2:

i) Standard cost per unit, plus an additional charge per unit based on a 5% per annum return on average stocks and work in progress and on fixed assets

13 marks

ii) Standard variable cost per unit, plus a fixed monthly charge invoiced by Devon and Somerset divisions to Dorset division equal to their total fixed overhead costs together with a 5% per annum return on the current average stocks, work in progress and fixed assets.

7 marks

b) Discuss which of the two transfer pricing rules is likely to be preferred by the managing director of Dave Ltd. Maximum 200 words.

5 marks

Total: 25 marks