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In example that I had in Kaplans book about Able and Baker being two divisions of the same group. Where Able manufactures X and sells it externally at £42 per unit and Y, which it sells to Baker. Y is also obtainable externally for £38. Cost are for X 32 var. and 5 fixed and for Y 35 var. and 5 fixed per unit.
the task is to determine a TP
1. when spare capacity exists and limited demand for X and
2. full capacity and unlimited demand for X.in first case it is clear TP is set at marginal cost or between 35 and 38.
in the second case TP is diffucult to determine, as we have to compensate Able for loss of contriubtion of not selling X externally and produce and Y and TP should be set at 35 + 10 (opp. cost). As for Baker it will never buy at this price will buy externally.What should the correct answer be? 10 lost contribution is greater than saving from buying in 38 less 35? then encourage Able sell externally X and Baker externally Y for 38. The Groups profits will be maximised then? then no TP is makeable right?
Similar example is in your revision notes “business solution”.
The answer is discourage the consultant go North? Will it maximise group profits? I understand that in this case, when externally purchase of consultancy is possible for 500, then we set a maximum at a lower than Net marginal revenue and external purchase price.
Here it is 1100 and 500. So TP is not makeable then, as South will want to be compensated for loss of contribution 600 and North cannot accept a price higher than 500.
in your solution the relevant pricing calculation of loss of contribution 600 greater than relevant saving 400 is similar to the above example of Able and Baker.Thanks.
For Able and Baker, it is certainly best for the group if Able sells X externally and Baker buys Y externally. In order to make sure that the managers themselves decide to do this the transfer price should be set at anything between 38 and 45. If this is done, then Able will prefer to sell externally and Baker will prefer to buy externally – which is what the group wants them to do.
It is the same logic with North and South.
(Both questions (and their answers) are from old Paper P5 exams – it was in the days long ago when transfer pricing was only examined at P5, not at F5 🙂 )
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