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Transfer Pricing
A transfer price is the price charged when one segment of a company provides goods or services to another segment of
the company. The fundamental objective in setting transfer prices is to motivate managers to act in the best interests of
the overall company.
Primary Objective
To evaluate performance by virtually transforming cost centers into profit centers so that performance of the
manager of mainly cost centers can be measured reliably in terms of both revenues and expenses.
Secondary Objective
To save on costs involved in producing or buying a product by in-sourcing rather than outsourcing.
A negotiated transfer price results from discussions between the selling and buying divisions.
Many companies set transfer prices at either the variable cost or full (absorption) cost incurred by the selling division.
A market price (i.e., the price charged for an item on the open market) is often regarded as the best approach to the
transfer pricing problem.
1. A market price approach works best when the product or service is sold in its present form to outside customers
and the selling division has no idle capacity.
2. A market price approach does not work well when the selling division has idle capacity.
For transfer pricing not to defeat its purpose, organization normally sets a limitation as to the transfer price being charged
by one segment to the other segments. To minimize the effect of sub-optimization, a range for transfer price must be set
based on the following limits:
UPPER LIMIT: Maximum transfer price = Cost of buying from outside suppliers or selling price to outside customers,
whichever is higher
LOWER LIMIT: Minimum transfer price = Variable cost per unit + Lost CM per unit on outside sales
When a company segment is operating at full capacity, the lost CM per unit on outside sales is the opportunity cost of
transferring products to another company segment, instead of selling products to outside customers.
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Dual Pricing Concept
The “selling” center could transfer to another segment at the usual market price that would be paid by an outsider. The
“buying” center, however, would record a purchase at the variable cost of production. This practice is now rarely applied
because neither manager from both the buying and selling center must exert much effort to show a profit on a segmental
performance reports.
Capacity factors
Does the seller have excess capacity to accommodate further inter-segment transfer?
Smallville Company’s Division A produces a small tool used by other companies as a key part in their products. Cost and
sales data relating to the small tool are given below:
Selling price per unit P 50
Variable cost per unit 30
Fixed costs per unit * 12
The company’s Division B is introducing a new product that will use a tool such as the one produced by Division A. An
outside supplier has quoted the Division B a price of P48 per tool. Division B would like to purchase the tools from Division
A, if an acceptable transfer price can be worked out.
Required:
The Royal Company is operating with two divisions. Division H is producing a product line that is required as a component
part of the product being manufactured by Division W.
For Division H, the costs of producing the component part per unit are:
Direct materials P 10
Direct labor 8
Variable factory overhead 5
Fixed factory overhead 2
The product of Division H is being sold in a highly competitive market for P30 per unit.
Division W is currently buying 80% of the production output of Division H at a negotiated price of P28 per unit. It is
expected that 25,000 units of product will be produced by Division H.
With emphasis on divisional welfare rather than the company’s welfare, a new transfer price must be developed. It is
suggested that a 40% mark-up on cost will be added when transferring the product from Division H to Division W.
An additional processing cost for Division W is P8 per unit. The selling price of the product of Division W is P45 per unit.
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Required: Determine the gross profit per unit of the product from Division W under each of the following independent
assumptions:
a. Transfer price is full-cost based. c. Transfer price is based on a negotiated price.
b. Transfer price is cost-based plus mark-up. d. Transfer price is market-based.
Sprite Corporation produces goods in the United States, to be sold by a separate division located in Italy. More
specifically, the Italian division imports units of product X34 from the U.S. and sells them for P950 each. (Imports of
similar goods sell for P850.) The Italian division is subject to a 40% tax rate whereas the U.S. tax rate is only 30%. The
manufacturing cost of product X34 in the United States is P720. Furthermore, there is a 10% import duty, computed on
the transfer price, that will be paid by the Italian division and is deductible when computing Italian income.
Tax laws of the two countries allow transfer prices to be set at U.S. manufacturing cost or the selling prices of
comparable imports in Italy.
Required: Analyze the profitability of the U.S. division and the Italian division to determine whether Sprite as a whole
would be better off if transfers took place at (1) U.S. manufacturing cost or (2) the selling price of comparable imports.
Summary:
The negotiated price is determined through agreement of division managers. Under a cost based approach, the
transfer price may be based on variable cost alone or on variable cost plus fixed costs. Companies may add a markup to
these numbers. The cost-based approach often leads to poor performance evaluations and purchasing decisions. A
market-based transfer price is based on existing competing market prices and services. A market-based system is often
considered the best approach because it is objective and generally provides the proper economic incentives.
EXERCISES
1. Transfer prices
a. reduce employee turnover.
b. are necessary for investment centers.
c. should encourage the kinds of behavior that upper-level management wants.
d. are not used for departments with high amounts of fixed costs.
2. A transfer price is
a. an accounting device to turn profit centers into investment centers.
b. the price charged by one segment of the company for goods or services provided to another segment.
c. only useful in a segment that deals with outsiders as well as with other segments of the same company.
d. the amount charged by a cost center for a service performed for a profit center.
3. To avoid waste and maximize efficiency when transferring products among divisions in a competitive economy, a
large diversified corporation should base transfer prices on
a. variable cost b. market price c. full cost d. production cost
8. With two autonomous division managers, the price of goods transferred between the divisions needs to be
approved by
a. corporate management.
b. both divisional managers.
c. both divisional managers and corporate management.
d. corporate management and the manager of the buying division.
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9. The minimum potential transfer price is determined by
a. incremental costs in the selling division.
b. the lowest outside price for the good.
c. the extent of idle capacity in the buying division.
d. negotiations between the buying and selling division.
10. If a firm operates at capacity, the minimum transfer price should be the:
a. external market price less any cost savings c. actual cost
b. differential cost d. standard cost
13. The minimum transfer price should be the additional cost plus:
a. opportunity cost for selling division c. opportunity cost for the company as a whole
b. opportunity cost for buying division d. a share on selling division’s fixed costs
14. Which item is usually not relevant to a decision by the divisional manager to reduce the transfer price to meet a
price offered to the buying division by an outside supplier?
a. opportunity cost c. fixed divisional overhead
b. variable manufacturing costs d. the price offered by the outside supplier
15. The High Division of Para Company produces a high quality kite. Unit production costs (based on capacity
production of 100,000 units per year) follow:
Direct materials P 60
Direct labor 25
Overhead (20% variable) 15
Other information
Sales price 120
Selling expenses (15% variable) 20
What is the minimum selling price that the division would consider as a “transfer price” to the Recreation Division
on which no variable period costs would be incurred?
a. P120 b. P88 c. P91 d. P117
Division B, another division in the company, would like to buy this part from Division A. Division B is presently
purchasing the part from an outside source at P28 per unit. If Division A sells to Division B, P1 in variable costs can
be avoided.
Suppose Division A is currently operating at capacity and can sell all of the units it produces on the outside market
for its usual selling price. From the point of view of Division A, any sales to Division B should be priced no lower
than:
a. P27 b. P29 c. P20 d. P28
17. AutoTech's Northern Division is currently purchasing a part from an outside supplier. The company's Southern
Division, which has no excess capacity, makes and sells this part for external customers at a variable cost of P19
and a selling price of P31. If Southern begins sales to Northern, it (1) will use the general transfer-pricing rule and
(2) will be able to reduce variable cost on internal transfers by P3. On the basis of this information, Southern would
establish a transfer price of:
a. P16 b. P19 c. P28 d. P31
18. An appropriate transfer price between two divisions of the Star Corporation can be determined from the following
data:
Fabrication Division
Market price of subassembly P50
Variable cost of subassembly P20
Excess capacity (in units) 1,000
Assembling Division
Number of units needed 900
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19. The Pro Division of Custom Industries is in need of a particular service. The service can be obtained from another
division of Custom at "cost," with cost defined as the summation of variable cost (P9) and fixed cost (P3).
Alternatively, Pro can secure the service from a source external to Custom for P10. Which of the following
statements is true?
a. Pro should compare P10 vs. P3 in deciding where to acquire the service.
b. Pro should compare P10 vs. P12 in deciding where to acquire the service.
c. From Custom's perspective, the proper decision is reached by comparing P10 vs. P9.
d. Both "b" and "c" are true.
20. Which of the following describes the goal that should be pursued when setting transfer prices?
a. Maximize profits of the buying division.
b. Maximize profits of the selling division.
c. Allow top management to become actively involved when calculating the proper dollar amounts.
d. Establish incentives for autonomous division managers to make decisions that are in the overall organization's
best interests (i.e., goal congruence).
The Wood Division of Fir Products, Inc. manufactures rubber moldings and sells them externally for P110. Its
variable cost is P50 per unit, and its fixed cost per unit is P14. Fir's president wants the Wood Division to transfer
5,000 units to another company division at a price of P64.
21. Assuming the Wood Division has available capacity of 5,000 units, the minimum transfer price it should accept is
a. P14 b. P50 c. P64 d. P110
22. Assuming the Wood Division does not have any available capacity, the minimum transfer price it should accept is
a. P14 b. P50 c. P64 d. P110
23. If a firm operates at capacity, the minimum transfer price should be the:
a. external market price less any cost savings. c. actual cost
b. differential cost d. standard cost
26. The minimum transfer price should be the additional cost plus:
a. opportunity cost for selling division. c. opportunity cost for the company as a whole.
b. opportunity cost for buying division. d. a share on selling division’s fixed costs.
27. Which item is usually not relevant to a decision by the divisional manager to reduce the transfer price to meet a price
offered to the buying division by an outside supplier?
a. opportunity cost c. fixed divisional overhead
b. variable manufacturing costs d. the price offered by the outside supplier
Notre Company transfers a product from Division N to Division R. Variable cost of this product is anticipated to be P40
a unit and total fixed costs amount to P8,000. A total of 100 units are anticipated to be produced. Actual cost,
however, amounts to P50 for variable costs. Fixed costs expected to continue as budgeted. However, the actual
output is twice as the number of budgeted.
29. What is the transfer price based on actual variable costs plus 130% markup?
30. What is the transfer price based on budgeted full cost plus 30% markup?
Division Daimos, which currently buys the same product from an outside supplier for P230 per unit, would like to buy
the product from Division Maskman.
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Division Maskman will use one-half of its idle capacity if it decides to provide the requirements of Division Daimos.
31. What is the minimum price that Division Maskman should charge Division Daimos for this product?
a. P100 b. P150 c. P250 d. P230
32. Using the same data in No. 31, what is the maximum price that Division Daimos will be willing to pay for the
product if its will be purchased internally?
a. P100 b. P150 c. P250 d. P230
I. Income taxes and import duties are an important consideration when setting a transfer price for companies
that pursue international commerce.
II. Transfer prices cannot be used by organizations in the service industry.
III. Transfer prices are totally cost-based in nature, not market-based.
34. Signature Scents has two divisions: the Cologne Division and the Bottle Division. The Bottle Division produces
containers that can be used by the Cologne Division. The Bottle Division's variable manufacturing cost is P200,
shipping cost is P10, and the external sales price is P300. No shipping costs are incurred on sales to the Cologne
Division, and the Cologne Division can purchase similar containers in the external market for P260.
The Bottle Division has sufficient capacity to meet all external market demands in addition to meeting the
demands of the Cologne Division. Using the general rule, how much will be the transfer price from the Bottle
Division to the Cologne Division? 200/240
35. Using the same information in number 34, and assume the Bottle Division has no excess capacity and could sell
everything it produced externally. Using the general rule, how much will be the transfer price from the Bottle
Division to the Cologne Division? 290/260
36. A and T Company transfers a product from Division A to Division T. Variable cost of this product is anticipated to
be P400 a unit and total fixed costs amount to P 80,000. A total of 100 units are anticipated to be produced.
Actual cost, however, amounts to P500 for variable costs. Fixed costs were same as budget. However, actual
output was twice as many. What is the transfer price based on budgeted full cost plus a 40% mark-up? 1,680
37. Given no idle capacity and a competitive market exists, that is, all goods transferred internally can be sold
externally, the optimal method for establishing the transfer price is the market price method, where the transfer
price is equal to
a. outlay cost plus opportunity cost c. opportunity cost
b. outlay cost d. cost plus any mark-up