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Dear Mr John,
Good day.
Please help to explain the question as follows.
A company has a divisonalised structure in which Division A transfer its output to Division B. There is no external market for the transferred item and the cost will be used as the basis for setting a transfer price. Which 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 costI wrongly selected a) and the answer is d). Please help with your explanation.
Thank you.
Warmest regards,
Eric LamOf the four choices (d) is best.
Firstly because using actual cost (or actual cost plus a profit margin) means there is no incentive for Division A to cut costs.
Secondly, using standard cost alone would give A an incentive to try and cut costs, but if the standard cost has been fixed sensibly (and therefore they will be unlikely to cut costs more) then Division A would be getting no profit and so would not have an incentive to even produce the goods.
Dear Mr John,
Thank you for your clear explanation.
However, B may feel unfair being charge with higher cost as this will pull down its division profit margin. Overall company profit suffered if B stop production. If this is the case, how to prevent this from happening. Please advice with your explanation.
Thank you.
Warmest regards,
Eric LamThe way to avoid it happening is to determine a sensible transfer price using the rules I go through in my free lectures, and not to use a transfer price simply based on cost.
I do explain all of this, with examples, in my lectures.
The lectures are a complete free course for Paper PM and cover everything needed to be able to pass the exam well.
Dear Mr John,
In that case, the suitable transfer price must be based the lowest cost of all, the actual cost more close to marginal cost, so performance measurement, divisional autonomy and company profit is maximized. Please advice and thank you very much.
Warmest regards,
Eric LamThe minimum transfer price should be the marginal cost plus any lost contribution.
Again, please watch my free lectures because I explain in detail in my lectures (and you cannot expect me to type them all out here 🙂 )
I watched your lectures and learned the rules that minimum transfer price is marginal cost + any lost contribution. My question is can this rule be applied to the above question, i.e. a) actual cost is the lowest cost among all of them. Please advice. Thank you.
I have already answered your question. Of course you cannot use the rule because that is not one of the choices. The question asks which of the four choices given would be the best – it does not ask what they should do!
Dear Mr John,
Thank you for your excellent explanation.
Warmest regards,
Eric Lam
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