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Division B of a company makes units which are then transferred to other divisions. The division has no spare capacity. The following statements have been made regarding the minimum transfer price that will encourage the divisional manager of B to transfer units to
other divisions:
(1) Any price above variable cost will generate a positive contribution, and will therefore
be accepted.
(2) The division will need to give up a unit sold externally in order to make a transfer;
this is only worthwhile if the income of a transfer is greater than the net income of an
external sale.
Which of the above statement(s) is/are true?
A (1) only
B (2) only
C Neither (1) nor (2)
D Both (1) and (2)The right answer is B but can,t find any logic behind it.
Division B does not sell externally so why the income on internal transfer need to be greater than external sale?B is certainly the correct answer!
Why do you say that B does not sell externally? They will choose to sell externally if they can get more externally than they can by selling to other divisions!!!
I do suggest that you watch my free lectures on transfer pricing – then this should make sense immediately 🙂
The lectures are a complete free course for Paper F5 and cover everything needed to be able to pass the exam well.
@johnmoffat said:
B is certainly the correct answer!Why do you say that B does not sell externally? They will choose to sell externally if they can get more externally than they can by selling to other divisions!!!
I do suggest that you watch my free lectures on transfer pricing – then this should make sense immediately 🙂
The lectures are a complete free course for Paper F5 and cover everything needed to be able to pass the exam well.
I watched your lecture on transfer pricing.
But what about the whole company profit maximization?If they are transferring to another division at more price than the cost of buying division will be more hence the overall company profit maximization will not be achieved.
Also in the above question if option 1 is not correct then how come the company be earn contribution hence income on internal transfers?You have not read the question carefully. It does not ask about whole company profit maximisation.
It asks for “the minimum price that will encourage the divisional manager of B to transfer units to other divisions”.
I actually write down on the screen in my lecture, that the minimum transfer price is set by the transferring division (in this case B) and is the marginal cost plus any lost contribution that could have been made by selling externally. That is effectively what choice B is saying.
I do suggest that you watch my lectures again.
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