(a) Price under existing policy

$

Steel (0·4/0·95 x $4·00)                  1·68

Other materials ($3·00 x 0·9 x 0·1)         0·27

Labour (0·25 x $10)                     2·50

Variable overhead (0·25 x $15)            3·75

Delivery                              0·50

––––––

Total variable cost                      8·70

Mark-up 30%                          2·61

––––––

Transfer price                         11·31

                                    ––––––

(b) The only difference would be to add the fi xed costs and adjust the mark-up %.

$

Existing total variable cost               8·70

Extra fi xed cost (0·25 x $15 x 0·8)         3·00

––––––

Total cost                            11·70

Mark-up 10%                         1·17

––––––

Transfer price                         12·87

––––––

The price difference is therefore 12·87 – 11·31 = $1·56 per unit

(c) As far as the manufacturer is concerned, including fi xed costs in the transfer price will have the advantage of covering all the costs incurred. In theory this should guarantee a profi t for the division (assuming the fi xed overhead absorption calculations are accurate). In essence the manufacturer is reducing the risk in his division.

The accounting for fi xed costs is notoriously diffi cult with many approaches possible. Including fi xed costs in the transfer price invites manipulation of overhead treatment.

One of the main problems with this strategy is that a fi xed cost of the business is being turned into a variable cost in the hands of the seller (in our case the stores). This can lead to poor decision-making for the group since, although fi xed costs would normally be ignored in a decision (as unavoidable), they would be relevant to the seller because they are part of their variable buy in price.

(d) Degree of autonomy allowed to the stores in buying policy.

If the stores are allowed too much freedom in buying policy Hammer could lose control of its business. Brand could be damaged if each store bought a different supplier’s shears (or other products). On the other hand, flexibility is increased and profits could be made for the business by entrepreneurial store managers exploiting locally found bargains. However, the current market price for shears may only be temporary (sale or special offer) and therefore not really representative of their true market ‘value’. If this is the case, then any long-term decision to allow retail stores to buy shears from external suppliers (rather than from Nail) would be wrong.

The question of comparability is also important. Products are rarely ‘identical’ and consequently, price differences are to be expected. The stores could buy a slightly inferior product (claiming it is comparable) in the hope of a better margin. This could seriously damage Hammer’s brand.