Avery Company has two divisions, Polk and Bishop. Polk produces an item that Bishop could use in its production. Bishop currently is purchasing 24,000 units from an outside supplier for $15 per unit. Polk is currently operating at less than its full capacity of 590,000 units and has variable costs of $7 per unit. The full cost to manufacture the unit is $10. Polk currently sells 450,000 units at a selling price of $18 per unit.

a. What will be the effect on Avery Company's operating profit if the transfer is made internally?

b. What is the minimum transfer price from Polk's perspective?

c. What is the maximum transfer price from Bishop's perspective?

Answer and Explanation:

a. The computation of operating profit is shown below:-

Profit per unit = Purchase price from outside per unit + variable cost of production internally

= $15 - $7

= $8

Total increment in operating profit = Profit per unit * Total number of units

= $8 * 24,000

= $192,000

b. Minimum transfer price = Variable cost = $7 (because polk has overcapacity and there is no change in fixed cost and polk minimum has to recover its variable production cost)

c. Maximum transfer price = purchase cost from outside supplier = $15 (because if the internal transfer piece is more than $15 Bishop will lose so he prefers to buy from outside and the company as a whole will lose $192,000 in incremental operating profit