TRANSFER PRICING – Additional

Lecture

TRANSFER PRICE – The amount charged

by one segment of the organization for
goods/services transferred/provided to
another segment of the same
organization
 Factors considered in selecting a transfer
pricing policy
i. GOAL CONGRUENCE
a. One purpose of responsibility accounting system
b. It is a condition where employees, working on their own personal interest
of their responsibility center, make decisions that help meet the overall
goals of the firm
c. A transfer price should permit a segment to operate as an independent
entity and achieve its goals while functioning in the best interests of the
organization as a whole
ii. SEGMENTAL PERFORMANCE – the selling segment should not lose income by
selling within the company.
iii. NEGOTIATION – the buying segment should not incur greater costs by buying
within the company. Hence if the product or service could be purchased
outside the company, the buying segment should be allowed to negotiate the
transfer price.
 Factors considered in selecting a transfer
pricing policy
iv. CAPACITY – If the selling segment has excess capacity, it
should be used to produce goods for transfer within the
company. If there is no excess capacity, the selling segment
should not incur loss by selling to another segment within the
same organization.
v. COST STRUCTURE – Costs to be considered in a transfer
price should be analyzed and broken down into variable and
fixed components, so that it would be easier to identify
relevant cost items.
Ways of determining Transfer Prices
1. Market price if a market for the goods/services exists
A transfer price equal to the prevailing market price encourages
both the selling and the buying segments to sell/buy internally
2. Incremental costs plus opportunity cost to the seller
The opportunity cost is usually the contribution margin to be lost
from outside customers if the goods are transferred to a buying
segment within the firm. This transfer price is the minimum
amount that the selling segment would be willing to transfer
goods/services to another segment
3. Full Absorption Cost
The transfer price includes materials, labor and allocated fixed
factory overhead
Ways of determining Transfer Prices
4. COST PLUS MARKUP
This markup may be a lump sum (₱) or markup percentage. Cost may be the
standard cost or actual cost
5. NEGOTIATED TRANSFER PRICE
A negotiated transfer price is appropriate when market prices are subject to
rapid fluctuations. In negotiating a transfer price, the range is:
• Minimum Price – (seller’s point of view) – seller’s incremental cost plus opportunity cost
• Maximum Price (buyer’s point of view) – the prevailing market price
6. DUAL TRANSFER PRICE
The seller records the transfer price at the usual market price that would be
paid by an outsider, while the buyer (another segment within the firm)
records the purchase cost at cost usually the variable production cost.
General-Transfer-Pricing Rule

Additional outlay Opportunity cost

cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

13-6
Scenario I: No Excess Capacity
• The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
• The Battery division is currently selling 300,000
batteries to outsiders at $40. The Auto Division can use
100,000 of these batteries in its X-7 model.

What is the appropriate transfer price?

13-7
Scenario I: No Excess Capacity
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

$22 Contribution
Transfer $18 variable
price
= cost per battery
+ lost if outside
sales given up
Transfer
price
= $40 per battery
13-8
Scenario I: No Excess Capacity

Auto division can Auto division can

purchase 100,000 purchase 100,000
batteries from an batteries from an
outside supplier outside supplier
for less than $40. for more than $40.

Transfer Transfer
will not $40 will
occur. transfer occur.
price
13-9
Scenario I: No Excess Capacity
General Rule
When the selling division is operating at
capacity, the transfer price should be
set at the market price.

13-10
Scenario II: Excess Capacity
• The Battery Division makes a standard 12-volt battery.
Production capacity 300,000 units
Selling price per battery $40 (to outsiders)
Variable costs per battery $18
Fixed costs per battery $7 (at 300,000 units)
• The Battery division is currently selling 150,000
batteries to outsiders at $40. The Auto Division can use
100,000 of these batteries in its X-7 model. It can
purchase them for $38 from an outside supplier.

What is the appropriate transfer price?

13-11
Scenario II: Excess Capacity
Additional outlay Opportunity cost
cost per unit per unit to the
Transfer
price
= incurred because + organization
goods are because of
transferred the transfer

Transfer $18 variable

price
= cost per battery
+ $0

Transfer
price
= $18 per battery
13-12
Scenario II: Excess Capacity
General Rule
When the selling division is operating
below capacity, the minimum transfer
price is the variable cost per unit.

So, the transfer price will be no lower

than $18, and no higher than $39.
13-13
Scenario II: Excess Capacity

Transfer Transfer Transfer

will not will will not
occur. occur. occur.

$18 $39
transfer transfer
price price

13-14
SAMPLE PROBLEMS # 1
The N Division sells goods internally to the S Division of the same
company. The prevailing price of N Division’s product is ₱500 per unit
plus transportation cost of ₱100 to transfer the goods to S Division.

Northern incurs the following costs per unit in producing the goods:
Materials ₱250
Direct Labor 75
Storage and handling 60
₱385
If the market based transfer pricing method is to be used, what is the
transfer price?
Answer : ₱600. If the market-based pricing is used which is the sum of
prevailing external (market) price and the transportation cost
Sample Problem # 2
Division U of P Company is currently operating at full capacity of 5,000
units. It sells all its production in a perfectly competitive market for
₱250 per unit. Its variable cost is ₱170 per unit, while its total fixed cost
amounts to ₱300,000.

What is the minimum transfer price that should be charged to Division

U of P Company for each unit of product transferred.
Answer: ₱250. In a perfectly competitive market, the market price is
the appropriate transfer price.
 Sample Problem # 3
Division 1 of L Company is currently operating at 70% of its capacity. It produces a single product
and sells all its production to outside customers for ₱70 per unit. Variable costs is ₱30 per unit and
fixed cost is ₱20 per unit at the current production level

Division 2, which currently buys the same product from an outside supplier for ₱65 per unit, would
like to buy the product from Division 1

Division 1 will use one-half of its idle capacity if it decides to provide the requirements of Division
2.

a. What is the minimum price that Division 1 should charge Division 2 for the product?
Answer: ₱30. Since idle capacity exists, opportunity cost is equal to zero. The minimum price that must be
charged to the product is equal to the variable cost per unit
b. What is the maximum price that Division 2 will be willing to pay for the product if it will be
purchased internally?
Answer: ₱65. Considering the point of view of the buying segment, the maximum transfer price acceptable
is equal to the purchase price of the goods if acquired from outside suppliers.
1.McKenna's Florida Division is currently purchasing a
part from an outside supplier. The company's Alabama
Division, which has excess capacity, makes and sells this
part for external customers at a variable cost of $22
and a selling price of $34. If Alabama begins sales to
Florida, it (1) will use the general transfer-pricing rule
and (2) will be able to reduce variable cost on internal
transfers by $4. If sales to outsiders will not be affected,
Alabama would establish a transfer price of:

Answer: 18
Green Auto's Northern Division is currently purchasing a part
from an outside supplier. The company's Southern Division,
which has no excess capacity, makes and sells this part for
external customers at a variable cost of $19 and a selling price
of $31. If Southern begins sales to Northern, it (1) will use the
general transfer-pricing rule and (2) will be able to reduce
variable cost on internal transfers by $3. On the basis of this
information, Southern would establish a transfer price of:

Answer: 28
• General Auto's Northern Division is currently purchasing a
part from an outside supplier. The company's Southern
Division, which has excess capacity, makes and sells this part
for external customers at a variable cost of $19 and a selling
price of $31. If Southern begins sales to Northern, it (1) will
use the general transfer-pricing rule and (2) will be able to
reduce variable cost on internal transfers by $3. On the basis
of this information, Southern would establish a transfer price
of:

Answer: 16
• Underwood Company uses cost-based transfer pricing. Its Food
Processing Division has a standard variable cost of $8.50 per case and
allocated fixed overhead of $2.25. The Processing Division, which has
excess capacity, sells its output to external customers for $12.00 per
case. If Underwood uses variable costs as its base, the transfer price
charged to its Retail Division should be:

• Answer: $8.50 plus a markup.