Transfer Pricing

Hi Sir,

I am not clear on the following from ROTECH exam question from June 2014.
Specifically C Co manufactures components for gearbox and sells them to Gearbox Division.
C Co is working at full capacity, and the group policy is that group companies and divisions MUST always make internal sales first before selling outside the group. Similarly purchases must be made within the group where possible. C Co has always charged the same price to Gearbox division as it does to its external customers. Also, C Co satisfies 60% of external demand and its variable costs represents 40% of the revenue.

For C Co we have:

External Sales $8,010
Internal Sales $7,550

What is the minimum transfer prices that C Co is willing to pay?

1. Here I have a doubt. If the company policy states that C Co MUST always make internal sales first, how can be relevant in my transfer pricing calculation that C Co satisfies 60% of external demand? (and so in theory we could satisfy first the remaining 40% external demand which is $5,340 and then selling the remaining $2,210 ($7,550 – $5,340) at marginal cost which is $884 ($2.210*0.40).

2. I appreciate the concept of spare capacity in TP is key. By spare capacity I understand what is left after I fulfill all the potential EXTERNAL sales demand.

Given this:
– if there IS spare capacity, my sales price for external sales has to be the same for internal sales
-if there ISN’T spare capacity, my sales price for internal sales equals the marginal cost (or variable cost).
Please could you confirm if this is correct and it captures all the scenarios on spare capacity?

Thank you for taking the time to read it, I would really appreciate your help on this.

Leo