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Hello,
I had some doubts when I read your answer to the transfer pricing question in the “practice questions and answers” section at the back of the F5 course notes for OT.
Why haven’t you at all considered the fixed costs of product Y for $5 in part (i) and (ii)
I understand in (i) that there is spare capacity so no consideration is given for fixed costs but what about (ii)? We are clearly told that “operates at full capacity” so that means that the ‘real” transfer price for Y will be $45 (as explained in the answer) plus the fixed cost of $5. so $50?
When do we consider fixed costs in transfer pricing?
I am confused with this. Please help and thanks in advance.
The question you are referring to is in fact an old Paper P5 question (from the days when transfer pricing was only in the syllabus for P5 and not F5). The answer is the examiners own answer.
The division will have fixed costs, but we assume that the total fixed costs will stay the same whether we produce units for the other division or not. We therefore only need to consider marginal costs together with any lost contribution.
We would only consider fixed costs if either we were specifically told that the total fixed costs were going to change, or if we were told the company used a standard policy throughout the company that brought in an element of fixed cost (in which case it would be simply a question of following the rules – just as you could be told that the policy was cost plus, in which case, again, you would calculate in accordance with the company rules)
Thanks for your reply.
However, in my study text I’ve read the disadvantages of full cost plus, in transfer pricing, as follows:
1. Fixed costs of selling division become variable costs of buying division – may lead to dysfunctional decisions.
2. If selling division has spare capacity it may lead to dysfunctional decisions.So please explain points no.1 and 2. How do they lead to dysfunctional decisions.
And in considering the transfer price do we deduct external selling costs, if instead, we transfer internally so as to reduce the opportunity cost of lost contribution?
Thanks.
Exactly.
If the want to ensure goal congruent decisions, they should set transfer prices according the the rule explained in the lecture.
However it is very common in practice for companies to have a standard
policy throughout the company – it is easier to operate.One policy is full cost plus, and if you are given a company policy you just follow the instructions given in the question (but then be able to explain the potential problems (and if asked, be able to suggest a sensible tp range)
Including fixed costs would be a bad idea because the fixed costs in total will not change yet the receiving division would be being charged more the more units they bought. It could be that the resulting transfer price was too high resulting in a loss of goal congruence.
With regard to list contribution – contribution (as always) is the selling price less all variable costs.
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