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Sir,
Here’s a question which I got from BPP.
A company has a divisionalised structure in which Division A transfers its output to Division B. There is no external market for the transferred item and cost will be used as the basis for setting a transfer price. Which one of the following will be the most appropriate basis for negotiating and agreeing a transfer price?
A. Actual cost
B. Actual cost plus a profit margin equal to a percentage of cost
C. Standard cost
D. Standard cost plus a profit margin equal to a percentage of costThe answer given by BPP is D because it provides incentive to the division (e.g. division A) to make & transfer the item.
But I would like to know whether the answer would differ if there is an external market for the transferred item?
The answer could well differ if there is an external market (but only if there is a limit on the amount that can be produced).
You should watch the free lectures on transfer pricing where all of this is explained with examples.
(Our lectures are a complete course for Paper F5 and cover everything you need to be able to pass the exam well.)
I did watch the lectures. But I just wanna know which kind of cost would it differ to (either to B or C) if there’s an external market and a limited capacity.
It would be none of the answers.
Since you have watched the lectures you will know that the appropriate transfer price would be the marginal cost plus any lost contribution (which there would be if there was a limit on production).
Alright. Sir, one last thing on this question. what’s the difference between B and D?
One says actual cost and one says standard cost!!
(Standard cost is estimated in advance which is what we need since transfer price will have to be fixed in advance)
Sir, I have a question.
Suppose if division A transfers parts to division B and there external demand for A is 15000 units, internal demand is 5000 units and the maximum capacity of A is 18000 units. there exists a contract between division A and B to supply parts internally first.
The selling price and the current transfer is $10 and the variable cost is $6
So, in this case what would be the minimum transfer price?
If there is a contract to supply parts internally first, then the contract would have to state a price and transfer pricing would be irrelevant.
The purpose of setting a transfer price properly is to make sure divisional managers make decisions that are good for the company as a whole.
I assume that the selling price is the price at which Division A can sell externally.
In which case the minimum transfer price in order to achieve goal congruence would have to be $6 for the first 3,000 units transferred (they could not be sold externally and there would therefore be no lost contribution), and then $10 for the remaining 2,000 units transferred (the marginal cost plus the lost contribution of $4, because these 2,000 units could have been sold externally).
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