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Hello Tutor i hope you are doing well. I have doubt in one of the question of B.P.P Exam kit.
The following statements have been made about transfer pricing. Whether the following statement is true or false.
(2) Where a perfect external market price exists and unit variable costs and unit selling prices are constant, the opportunity cost of transfer will be external market price or external market price less savings in selling costs.
My doubt is with statement 2. Opportunity Cost has been defined as the value of benefit sacrificed and foregone. Which here will be lost Contribution in case internal sales is made rather than selling externally.
So shouldn’t the above statement be wrong. Rather they shall mention. the Transfer Price (instead of Opportunity Cost) will be external market price or external market price less savings in selling costs.
The statement is correct
The opportunity cost is the profit the division could make by selling the product in the marketplace, as opposed to selling the product internally.
If an external market exists for the product being transferred (and there is unsatisfied demand externally), the ideal transfer price will be the market price.
So it means the opportunity cost is the profit the division could make by selling the product in the marketplace less any savings in selling costs.
Tutor as you said “Opportunity cost is the profit the division could make by selling the product in the marketplace less any savings in selling costs”. I totally agree with you.
But the question states that “opportunity cost of transfer will be external market price or external market price less savings in selling costs”. Which is actually the formula for transfer price not opportunity cost.
Aren’t the 2 things different then?
I’ll try again:
For example, consider a division that makes hats.
The cost of making one hat is $2.
That division can sell the hat in the marketplace for the market price of $5. Therefore, the opportunity cost of selling the hat internally instead of externally is $3. The transfer price would then be $5.
$5 = $2 + $3
In this example the transfer price is the same as the market price. In more complex examples this might not be the case(outside the syllabus). So transfer prices are frequently based on or similar to market prices.Ma’am i understood this thing and this has also been well explained by sir in his video.
But if you read the statement correctly it states
“Where a perfect external market price exists and unit variable costs and unit selling prices are constant, the “OPPORTUNITY COST” of transfer will be external market price or external market price less savings in selling costs.
But as you mentioned in your last reply the opportunity cost is $ 3 and transfer price is External Market Price i.e. $5.
So shouldn’t the statement be false because it’s not the Opportunity Cost rather Tranfer Price that is External Market Price or External Market Price net of any savings..
I hope you understand my point.
The statement is correct
With the opportunity cost method, the transfer price is the variable cost plus the opportunity cost. Where the selling division can sell externally, the opportunity cost will be the contribution lost from selling internally rather than externally.
This transfer price ensures that anything in excess of this will incentivise the seller to sell. The buyer’s maximum price is the lower of divisional net revenue and market price. Anything lower than this will incentivise the buyer to buy.
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