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This question is number 70.9 in BPP
In a company with a divisionalised structure, Division A transfers its output to Division B. Division A produces just one item, Component X. Division B makes and sells and end product that requires one unit of Component X.
All of the following costs are $ per unit of X
Marginal cost of production in Division A $8
Fixed overhead cost of production $3
Cost of selling in the external market $1
Market price in the external market $16
Division B contribution from further processing $25
Component X before deducting the transfer costDivision A is working at full capacity.
The question asks, “what should be the minimum transfer price per unit of Component X in this situation?”
I understand that the minimum transfer price is the marginal cost + the opportunity cost . But the answer to this question is $8+ ($16- $1- $8)= $15
My question is why do they subtract the marginal cost and the cost of selling to the external market from the opportunity cost?
Please explain. Thanks very much.
The ‘rule’ is that the transfer price is the marginal cost plus any lost contribution.
The contribution lost by not being able to sell externally is the external selling price of 16, less the costs involved (selling (1) and manufacturing (8))
Which makes sense anyway – the net selling price externally is 16-1 = 15, so they need to charge a transfer price of at least 15.
The free lecture on transfer pricing will help you – I go through many examples like this one.
Sir,
The oppurtunity cost of not being able to sell is 16(SP)- 1 (Savings of selling cost). My question is 8$ excluded because it is “marginal Cost “ie. since marginal cost means additional cost of producing 1 more unit. Since u are not going to produce one more unit of X ur excluding 8.
can u also tell me what happens if 8 was a variable cost instead of marginal cost?
The opportunity cost of not being able to sell is not 16 -1 at all. You have not read my previous post properly.
The opportunity cost is the lost contribution, which is 16 – 1 – 8 = $7
The minimum transfer price is the marginal cost plus the lost contribution, which is 8 + 7 = $15.
Marginal cost means variable costs – they mean the same thing!!!!
You have clearly not watched my free lectures on transfer pricing, and I suggest that you do. The lectures are a complete free course for Paper PM and cover everything needed to be able to pass the exam well.
Hi Sir,
I have watched your transfer pricing videos and i did read your previous post. For me logically it felt like the oppurtunity cost was just 16-1 because marginal cost has to be incurred anyways beacuse without making the product you cant sell it. Thats why i asked if marginal here means the additional cost of making a unit. Thats All!!!
I got it clear now. thanks for the help
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