Transfer prices were examined in a previous examination. It is, however deemed knowledge for this paper and can be asked again. It is therefore repeated here for revision.
What is a transfer price?
The transfer price is the price that one division charges another division of the same company for goods or services supplied from one to the other. It is an internal charge – the ‘sale’ of one division is the ‘purchase’ of the other. Although it will be reflected in the results for each division individually, there is no effect in the accounts of the company as a whole.
Ideally transfer prices should:
- Be perceived as fair to both divisions and therefore good for performance measurement and management
- Provide profits for both divisions because profits are motivating
- Promote goal congruence so that divisions volunteer to do what is good for the group
- Promote autonomy ie minimise head office interference
hi sir! a small doubt!
Grey Co has two divisions, Division A and Division B. Division A manufactures
component T500 which it sells to Division B and to external customers. Division A
has an annual capacity to produce 20,000 units of component T500 and has
estimated external sales of 12,000 units of component T500 for the current year.
Each unit of component T500 costs $20 to make (made up of $15 of variable cost
and $5 of fixed cost). Division A sells component T500 to external customers for $22
each.
Division B needs to purchase 14,000 units of component T500 in the current year.
Assuming that decisions are made in the best interest of the company, what is
the minimum TOTAL cost which Division B would expect to pay to Division A
for supplies of component T500 for the current year (to the nearest whole $)
answer was,
Division A has the capacity to manufacture 20,000 units of component T500 each
year. In the current year, it has estimated external sales of 12,000 units. This leaves
spare capacity of 8,000 units; however, Division B needs 14,000 components.
As decisions are to be made in the best interest of the company, division A will sell
the 8,000 units from spare capacity to Division B at variable cost of $15 per unit only.
The other 6,000 units required by division B would need to be sold at $22 each,
which is the price which would be charged to external customers.
Therefore, the total cost is calculated as follows:
8,000 units x $15 = $120,000
6,000 units x $22 = $132,000
Total cost $252,000
The remaining 6,000 units would be available to sell externally at $22 per unit.
sir, we did learn that when theres limited production capacity its MC + OP C right?
Great and most easy to understand lecture on transfer pricing Sir, just need a clarification on solution of Example # 08 in lecture notes of this topic (Chp # 14).
In example, the product Y is making $3 per hour contribution for Division A but is being multiplied with $4 per hour contribution of product X, to get the minimum transfer price to Division B.
Can you please help me to understand this approach.
Regards.
I’m also struggling to understand the answers from the above example, does anyone have the solution?
Many thanks
Excellent transfer pricing lecture! Just one remark, Landual Lamps recommended question is from June 2013 P5 exam.
What is the best way to memorise all the different formulas I find it so hard. The lectures are brilliant but I tent to view so many I do confuse myself.
Very great lecture on transfer pricing!
what is marginal cost?
cost of producing an extra unit of a product.
Dear Sir,
There is one more example (Example 8 Page no. 100) in the notes and the solution given is not enough to understand.
There is no option to attach the picture but it can be accessed from the notes.
Problem : I cannot understand that why in the solution(pg no. 145) are they doing (10*4)??
These lectures are awesome.i pray Allah rewards you abundantly sir.
I would like to say that I love these new lectures! They are so well explained, even better than the online lectures that we pay £00s for! On the online lectures some of the tutors just seem to be reading from the study materials, without any personal contribution! Apart from the fact that is boring, it is demotivating! There isn’t even one example from real life, whilst here you get such examples!
So a big thank you!
Kindly clarify something for me, if the buying division has a limited quantity required (e.g 9) and the selling division (e.g 10) has more than that but a limited external market (e.g 4). Will it satisfy it external customer 1st and sell the remaining to the buying division?
The transfer price will it between its variable cost rate and the price the buying division can get it outside? Or inclusive of the amount lost contribution?
Kemi,
I will try to answer your two questions, I am hoping I will be correct:
1. When the transferring (selling) division has unlimited capacity and external demand is limited, it will usually first sell outside the organisation and then to the other divisions within the organisation. I believe the exception (when the selling division will only sell to other divisions in the organisation) is when the buying division has unlimited demand and they can pay at least the variable cost incurred by the selling division+the lost contribution of the selling division (effectively if the buying division can pay the market price)
2. When the buying division has limited demand and the selling division has unlimited capacity, the transfer price should be a minimum of variable cost for the selling division and the maximum cost that the buying division can pay without making a loss. So I think there are two different maximum transfer prices.
I will try to explain with some numbers:
– Selling division variable costs(marginal cost) for one unit of semi-finished good £10. This is the same as the minimum transfer price (remember, the minimum TP is always set by the selling division)
– Buying division needs to spend additional £2 in order to sell for £15. Also, it can buy the same semi-finished good from an external market for £12 or £14
Scenario 1: Buying it from an external market for £12 will generate a total cost for the Buying division of £12 + £2 (its own costs before being able to sell). Therefore its profit will be £1 (Selling price of £15-£12-£2). In this case, the max Transfer price can be £12
Scenario 2: buying it from an external market for £14 would generate a loss for the buying division (£15-£14-£2) therefore it will not choose to buy the semi finished good outside the organisation. In this scenario, the maximum price it will pay is what they call a marginal revenue for the buying division, which is the selling price less its own costs before being able to sell, therefore £15-£2 = £13
A very long answer, I hope you didn’t find it too complicated and that it helped. AND I hope I explained it correctly! Hopefully somebody will advise.
Good luck!
Really helpful. Thanks alot
I don’t like marginal cost plus a percentage for profit with transfer prcing. If division A becomes less efficient or pays more than it should for materials, their profit will go up and department B has to pay more.
A very helpful, useful, valuable, functional, purposeful (all the similar synonyms) video on transfer pricing.
Thank you very much Sir.