Fruities Ltd has two divisions, Durian Division and Juice Division. Durian Division has an annual capacity of 10 000 units of durian juice concentrate. Juice Division's annual requirement of durian juice concentrate is 8000 units. Fruities Ltd requires that divisions should purchase inputs internally where available and uses a cost-plus transfer price policy, where transfer price is set at variable cost plus 25 per cent. Therefore, Durian Division always satisfies the demand of the Juice Division first, before selling the remaining durian concentrate to external suppliers at the market price of $10 per unit. The variable cost of one unit of durian juice concentrate at Durian Division is $6.
What is the difference in Durian Division's profit under the cost-plus transfer price policy and a market-price transfer price policy?
A) Durian Division's profit is $20 000 lower under the cost-plus transfer pricing approach.
B) Durian Division's profit is $20 000 higher under the cost-plus transfer pricing approach.
C) Durian Division's profit is $25 000 lower under the cost-plus transfer pricing approach.
D) Durian Division's profit is $25 000 higher under the cost-plus transfer pricing approach.

Question

Quizplus · Accepted Answer

Under the cost-plus transfer price policy, Durian Division sells 8000 units of durian juice concentrate to Juice Division at a price of $9 per unit (variable cost of $6 plus 25%), resulting in revenue of $72 000. The remaining 2000 units are sold externally at the market price of $10 per unit, resulting in revenue of $20 000. 
Thus, total revenue under cost-plus transfer pricing is $92 000.

Under the market-price transfer price policy, Durian Division can sell all 10 000 units externally at the market price of $10 per unit, resulting in revenue of $100 000.
 
The difference in revenue is $100 000 - $92 000 = $8 000. However, this is not the difference in Durian Division's profit as we also need to consider the variable cost.

Under the cost-plus transfer price policy, Durian Division incurs a variable cost of $6 per unit, resulting in a total variable cost of $48 000 (8000 units sold internally to Juice Division + 2000 units sold externally). Durian Division's profit is then $92 000 - $48 000 = $44 000.

Under the market-price transfer price policy, Durian Division incurs a variable cost of $6 per unit for all 10 000 units sold externally, resulting in a total variable cost of $60 000. Durian Division's profit is then $100 000 - $60 000 = $40 000.

Therefore, the difference in Durian Division's profit under the two transfer price policies is $44 000 - $40 000 = $4 000. This means that Durian Division's profit is $20 000 lower ($4 000 x 5) under the cost-plus transfer pricing approach.

Fruities Ltd Has Two Divisions, Durian Division and Juice Division