Question

Mastery Problem: Transfer Pricing

Transfer Pricing

In many companies, one division may produce a product that is used by another division. When this happens, a price must be set for the product. This price is called the transfer price. The transfer price could be established by upper management or negotiated by division managers. In decentralized organizations, the transfer price is usually set by the managers of the divisions involved.

The transfer price that is established affect the evaluation of a selling division, which is a profit center. There are three methods commonly used to established the transfer price:

1. Market Price
2. Cost
3. Negotiated Price

Market Price Method

If an established market price exists, this may be the best amount to use as a transfer price. How this transfer price affects the income of each division and the overall corporation depends on whether the selling division is operating at capacity and selling every unit it produces.

Assume that Selling Division and Buying Division are both owned by Overall Corporation. Selling Division currently sells 100,000 units for $30 each. Each product costs $10 to produce. Fixed expenses are $150,000. Buying Division currently buys 15,000 units from Outside Company for $30 and sells each unit for $40. Fixed expenses for Buying Division equal $8,000.

Click on each scenario to view income statements.

1. No Transfer
2. Market Price without Excess Capacity
3. Market Price with Excess Capacity

Assume Selling Division has excess capacity of 15,000 units. If Selling Division sells product to Buying Division at market price, which of the following are true?

Overall Corporation will benefit from the transfer of product from Selling Division to Buying Division.
Selling Division’s net income will increase by selling 15,000 units to Buying Division.
Selling Division will give up sales to outside customers.
Buying Division’s net income will increase if it buys the units from Selling Division.
Buying Division has no incentive to buy from Selling Division, because its net income will be the same if it buys from Selling Division or Outside Company.
Selling Division’s net income will stay the same whether it sells the 15,000 units to Buying Division or not.

Negotiated Price Method

If excess capacity exists, market price is a good transfer price. Overall Corporation benefits from the transfer of product between Selling Division and Buying Division. However, there is no incentive for Buying Division to buy from Selling Division. Buying Division net income will be the same regardless of which supplier it uses. In order to give some incentive for Buying Division to buy from Selling Division, a negotiated price may be the best price to use as a transfer price. How this transfer price affects the income of each division depends on the price that is negotiated.

When the transfer price is negotiated, there is a maximum price above which Buying Division will not buy. There is also a minimum price below which Selling Division will not sell. The maximum price is equal to the

The minimum transfer price can be calculated in one of two ways:

Minimum Price = Market Price – Avoidable Costs. This formula ensures that the selling division is no worse off by selling to another division. When this formula is used, the range for the desirable transfer price is stated as: (Market Price – Avoidable Cost) < Transfer Price < Market Price.

Minimum Price = Variable Costs. This formula only looks at variable cost and not avoidable costs. When this formula is used, the range for the desirable transfer price is stated as: Variable Cost < Transfer Price < Market Price.

Assume that Selling Division and Buying Division are both owned by Overall Corporation. Selling Division currently sells 100,000 units for $30 each. Each product costs $10 to produce, of which $4 is avoidable for internal sales. Other fixed expenses are $150,000. Buying Division currently buys 15,000 units from Outside Company for $30 and sells each unit for $40. Fixed expenses for Buying Division equal $8,000. Selling Division has excess capacity of 15,000 units.

Click on each scenario to view income statements.

1. No Transfer
2. Minimum Price = Selling Price – Avoidable Costs
3. Minimum Price = Variable Costs
4. Maximum Negotiated Transfer Price
5. In Between Negotiated Transfer Price

Overall Corporation has two divisions, Buying Division and Selling Division. Currently, Buying Division buys product from an outside company for $40. Selling Division has excess capacity and sells the same product for $40. The product costs Selling Division $15, none of which is avoidable for internal sales. Which of the following are true? Check all that apply.

If the transfer price is $15, there is no benefit to Selling Division to sell to Buying Division.
If the transfer price is $16, there is no incentive for Selling Division to sell to Buying Division.
Both Buying Division and Selling Division will benefit from a transfer price of $20.
One formula for a desirable transfer price is: $20 < transfer price < $35.

Cost Method

If an established market price does not exist, product cost may be used for the transfer price. A market price may not exist when the Selling Division is making a product specifically for Buying Division and no other customers exist for this exact product. How this transfer price affects the income of each division and the Overall Corporation depends on whether the Selling Division is operating at capacity and whether it produces other products that it sells to outside customers.

Assume that Selling Division and Buying Division are both owned by Overall Corporation. Selling Division makes a product that is sold only to Buying Division. Selling Division is Buying Division’s only source of this product.

The cost method of setting a transfer price provides incentive to Selling Division regardless of whether it is organized as a cost, revenue, or profit center.
If Overall Corporation sets the transfer price at cost, there is no incentive for Selling Division to control production costs.
If Selling Division is organized as a profit center, selling a product at cost will not benefit the division.
If Buying Division is organized as a profit center, buying a product at cost will not benefit the division.

APPLY THE CONCEPTS: Determining benefits of negotiated transfer price

Assume that Selling Division and Buying Division are both owned by Overall Corporation. Selling Division sells a product that is used by Buying Division and outside customers. Selling Division has 27,000 units of excess capacity. Selling Division currently sells the product for $90 per unit and Buying Division currently buys 27,000 units of the product from an outside source for $90 per unit. Variable costs of the product are $18, of which $4.5 is the cost of selling the product to an outside customer.

Using Selling price less avoidable costs as the minimum price, fill in the following formula for the desired transfer price: $ < transfer price < $.

Using Variable costs as the minimum price, fill in the following formula for the desired transfer price: $ < transfer price < $.

Assume there are no avoidable costs with an internal sale (variable costs equal $18) and that Buying Division buys 27,000 units from Selling Division. Complete the table for each transfer price:

	Transfer Price	Transfer Price
	$85	$25
Increase in net income of Selling Division	$	$
Increase in net income of Buying Division	$	$
Increase in net income of Overall Corporation	$	$

Answer 1

Selling Price	$90
Avoidable costs	$4.50
	$85.50
Using selling price	$85.5< transfer price <$90
Using variable cost	$18< transfer price <$90

	$85	$25
Increase in net income of selling division	$1,809,000	$189,000
Increase in net income of buying division	$135,000	$1,755,000
Increase in net income of overall corporation	$1,944,000	$1,944,000

	$85	$25
Increase in net income of selling division	(85-18)*27000	(25-18)*27000
Increase in net income of buying division	(90-85)*27000	(90-25)*27000