Bath Co is a company specialising in the manufacture and sale of baths. Each bath consists

of a main unit plus a set of bath fittings. The company is split into two divisions, A and B. Division A manufactures the bath and Division B manufactures sets of bath fittings. Currently, all of Division A’s sales are made externally. Division B, however, sells to Division A as well as to external customers. Both of the divisions are profit centres.

The following data is available for both divisions:

The transfer price charged by Division B to Division A was negotiated some years ago between the previous divisional managers, who have now both been replaced by new managers. Head Office only allows Division A to purchase its fittings from Division B, although the new manager of Division A believes that he could obtain fittings of the same quality and appearance for $65 per set, if he was given the autonomy to purchase from outside the company. Division B makes no cost savings from supplying internally to Division A rather than selling externally.

Required:

(a) Under the current transfer pricing system, prepare a profit statement showing the profit for each of the divisions and for Bath Co as a whole. Your sales and costs figures should be split into external sales and inter-divisional transfers, where appropriate. (6 marks)

(b) Head Office is considering changing the transfer pricing policy to ensure maximisation of company profits without demotivating either of the divisional managers. Division A will be given autonomy to buy from external suppliers and Division B to supply external customers in priority to supplying to Division A.

Calculate the maximum profit that could be earned by Bath Co if transfer pricing is optimised. (8 marks)

(c) Discuss the issues of encouraging divisional managers to take decisions in the interests of the company as a whole, where transfer pricing is used. Provide a reasoned recommendation of a policy Bath Co should adopt. (6 marks)