18. Transfer Pricing

Question 1

Define Transfer Price.

Answer 1

Transfer price is the price at which one division transfers goods or services to another division within a company or from one subsidiary to another within a group.

Question 2

What are the objectives of transfer pricing? Explain them

Answer 2

1. Goal congruence
   Transfer prices should encourage divisional managers to make decisions in the best interests of the organisation as a whole.
2. Divisional Autonomy
   A transfer pricing system should help eliminate head office telling divisions what to do. This autonomy should improve the motivation of divisional managers.
3. Divisional performance evaluation
   Transfer prices should be fair and allow an objective assessment of divisional performance. The transfer price should permit each division to make a profit.

Question 3

The selling division will accept a minimum transfer price equal to?

Answer 3

Marginal (variable cost) + opportunity cost

Opportunity cost is usually the lost contribution from external sales, either of:
- the product subject to the transfer price or
- other products which the supplying division makes.

Question 4

Differentiate between the scenarios where the opportunity cost should be zero or more than zero.

Answer 4

Opportunity cost is zero when:
- no external market exists or there is an external market but spare capacity and
- no production constraints
In this scenario, opportunity cost is zero because internal transfers do not reduce contribution from external sales.

Opportunity costs arises when an internal sale sacrifices an external sale. Use this scenario when an external market exists and supplying division operates at full capacity.

Question 5

The maximum transfer price acceptable to the buying division will be the lower of:

Answer 5

• the external market price (if an external market exists) or
• the net revenue of the buying division

The net revenue of the buying division means the ultimate selling price of the goods/services sold by the buying division, less the cost of those goods incurred by the buying decision.

Question 6

Outline the market price method of transfer pricing.

Answer 6

A market price may be used if buying and selling divisions can buy/sell externally at market price. However, it may need to be adjusted downwards if internal sales incur lower costs than external sales (eg due to lower delivery costs).

Question 7

What are the advantages of the market price method?

Answer 7

1. Optimal for goal congruence if the selling division is at full capacity.
2. Encourages efficiency - the supplying division must compete with external competition.

Question 8

What are the disadvantages of the market price method?

Answer 8

1. Only possible if a perfectly competitive external market exists.
2. Market prices may fluctuate.

Question 9

Outline the full cost plus method of transfer pricing. Note that the variable cost plus method is similar.

Answer 9

Under the full cost plus method, the supplying division charges full absorption cost plus a markup. Standard costs should be used rather than actual costs to avoid selling divisions transferring inefficiencies to buying divisions.

Question 10

What are the advantages of the full cost plus method?

Answer 10

1. Easy to calculate if standard costing system exists.
2. Covers all costs of the selling division.
3. May approximate to market price.

Question 11

What are the disadvantages of the full cost plus method?

Answer 11

1. The fixed costs of the selling division become the variable costs of the buying decision - may lead to dysfunctional decisions.
2. If the selling division has spare capacity it may lead to dysfunctional decisions.
3. Mark-up is arbitrary.

Question 12

What is the formula utilised for the marginal cost method?

Answer 12

Marginal cost = variable cost + any incremental fixed costs eg stepped costs

Question 13

What are the advantages and disadvantages of the marginal cost method?

Answer 13

Advantages:
1. Optimal for goal congruence when:
- the selling division has spare capacity or
- no external market exists

Disadvantages:
1. May be difficult to calculate (variable cost if often used as an approximation).

Question 14

When is dual pricing used? How does it work?

Answer 14

Dual pricing is used where there is no transfer price the selling or buying divisions would accept and as such would not trade with each other. However, head office may want them to trade for non-financial reasons.

Dual pricing works as follows:
- a higher price is used when calculating the revenue of the selling division for goods supplied to the buying division.
- a lower price is used when calculating the costs in the buying division for goods supplied to it by the selling division.
- the head office absorbs the difference between the two as a head office overhead.