TRANSFER PRICING

Prepared by:
JADE BALLADO-TAN

Important Points...

Transfer pricing occurs when two or more

affiliated companies transact with one
another in an arms length nature involving
goods or services in the ordinary course of
business operations.

Important Points...

Transfer prices are often used by profit

centers and investment centers. Profit
centers are the more fundamental of these
two centers because investment centers are
responsible not only for revenues and costs
but also for invested capital.

Important Points...

The best transfer price is market price.

The cost-based price equals cost plus

lump sum or a markup percentage. Cost
may either be standard or actual cost.
Standard cost has the advantage of
isolating variances. Actual costs give the
selling division a little incentive to control
costs. Actual cost-based transfer pricingmay
not promote long-term efficiencies.

Important Points...

Negotiated transfer price may occur

when segments are free to determine the
prices at which they buy and sell internally.
It is especially appropriate when market
prices are subject to rapid fluctuations. It
reflects the best bargain price acceptable to
the selling and buying divisions without
adversely
sacrificing
their
respective
interest.

Important Points...

Arbitrary transfer pricing is set by the

management
in
the
corporate
headquarters. Its strength is anchored on
the premise that the entire corporate
organization has to promote its overall
goals over and above that of the divisions
goals. On the contrary, it does not jive well
with the very principle of decentralization
where authority is given to division
managers to make operating decisions.

Important Points...

Dual Pricing is used when the divisions,

selling and buying, use different prices in
recording their intercompany transfers. For
example, the selling division records the
transfer at market prices as if the sale is
made to outside customers, while the buying
division records the purchases at variable
cost
of
production.
Each
divisions
performance would improve using the dual
pricing scheme. In a sense, the variable cost
would be the relevant price to decision-

Important Points...
making purposes but the segments performance is
evaluated based on market prices. In this pricing
model, the sum of the profits of the individual
divisions would be greater that the overall profit
of the organization. This model reduces
managerial efforts to control costs. The seller is
assured of a high price, and the buyer is assured
of an artificially low price. This model is rarely
used in practice because division managers are
assured of a good segment performance and may
not exert much effort to report higher segment
margin.

Important Points...
Transfer pricing policy is normally set by top
management. The overall goal of the
organization is paramount. However, the
segments goal is also relevant.
When capacities are considered, transfer
price may be computed as the sum of the
incremental cost plus the opportunity costs
from the alternative use of capacity.

EXERCISES

Division X makes a part that it sells to customers outside

of the company. Data concerning this part appear below:
Selling price to outside customers ............. P75
Variable cost per unit ................................ 50
Total fixed costs ........................................ P400,000
Capacity in units ........................................
25,000
Division Y of the same company would like to use the part
manufactured by Division X in one of its products. Division
Y currently purchases a similar part made by an outside
company for P70 per unit and would substitute the part
made by Division X. Division Y requires 5,000 units of the
part each period. Division X has ample excess capacity to
handle all of Division Y's needs without any increase in
fixed costs and without cutting into outside sales of the
part. What is the lowest acceptable transfer price from the
standpoint of the selling division?

Check Figure

P 50

2. Division T of Clocker Company makes a

timer which it sells for P30 to outside
customers. The division has supplied the
following data concerning the timer:
Monthly capacity ........................... 12,000
timers
Variable cost per unit .................... P 15
Fixed cost per unit .........................
10
Presently, Division S of Clocker Company is
currently buying 5,000 similar timers each
month from an overseas supplier at P27
each. Division S would like to acquire its
timers from Division T if the price is right.

a. Suppose Division T is operating at

capacity and can sell all of the timers it
produces to outside customers at its usual
selling price. What is the lowest acceptable
transfer price from the viewpoint of the
selling division?

Answer:
P 30

b. Suppose Division T is operating at capacity

and can sell all of the timers it produces to
outside customers at its usual selling price.
If Division T meets the price of the overseas
supplier and sells 5,000 timers to Division S
each month, the effect on the monthly net
operating income of the company as a
whole will be:

Answer:
decrease of P15,000

c. Suppose that Division T can sell only

10,000 timers to outside customers, what
is the lowest acceptable transfer price
from the viewpoint of the selling division?

Answer:

P 24

3. Division 1 of Ace Company makes and sells wheels that

can either be sold to outside customers or transferred to
Division 2. The following data are available from last month:
Division 1:
Selling price per wheel to outside customers ............... P50
Variable cost per wheel when sold to outside customers .P35
Capacity in wheels ..................................................... 15,000

Division 2:
Number of wheels needed per month ........................... 5,000
Price per wheel paid to an outside supplier .................. P47
If Division 1 sells the wheels to Division 2, Division 1 can avoid
P2 per wheel in sales commissions.

a.

b.

c.

Suppose that Division 1 sells 7,500 units

per month to outside customers, what is
the lowest acceptable transfer price from
the viewpoint of the selling division if
Division 2 requires 5,000 units per month
from Division 1?
What is the maximum price per wheel
that Division 2 should be willing to pay
Division 1 if a transfer were to take place?
Suppose that Division 1 sells 11,500 units
each month to outside customers, what is
the lowest acceptable transfer price from
the viewpoint of the selling division?

Answers:
a.
b.
c.

P33
P47
P37.50

Fedori Corporation has a Parts Division that does work for

other Divisions in the company as well as for outside
customers. The company's Machinery Division has
asked the Parts Division to provide it with 4,000 special
parts each year. The special parts would require P23.00
per unit in variable production costs. The Machinery
Division has a bid from an outside supplier for the
special parts at P37.00 per unit. In order to have time
and space to produce the special part, the Parts
Division would have to cut back production of another
part-the YR24 that it presently is producing. The YR24
sells for P40.00 per unit, and requires P28.00 per unit in
variable production costs. Packaging and shipping costs
of the YR24 are P3.00 per unit. Packaging and shipping
costs for the new special part would be only P1.50 per
unit. The Parts Division is now producing and selling
15,000 units of the YR24 each year. Production and
sales of the YR24 would drop by 20% if the new special
part is produced for the Machinery Division.

Required:
a. What is the range of transfer prices within
which both the Divisions' profits would
increase as a result of agreeing to the
transfer of 4,000 special parts per year from
the Parts Division to the Machinery Division?
b. Is it in the best interests of Fedor
Corporation for this transfer to take place?
Explain.

Answer:
a. From the perspective of the Parts Division, profits would
increase as a result of the transfer if and only if:
Transfer price Variable cost + Opportunity cost
The opportunity cost is the contribution margin on the lost
sales, divided by the number of units transferred:
Opportunity cost = [(P40.00 - P28.00 - P3.00) 3,000*] / 4,000
= P6.75
* 20% 15,000 = 3,000
Therefore, Transfer price (P23.00 + P1.50) + P6.75 = P31.25.
From the viewpoint of the Machinery Division, the transfer
price must be less than the cost of buying the units from the
outside supplier. Therefore, Transfer price < P37.00.
Combining the two requirements, we get the following range of
transfer prices:
P31.25 Transfer price P37.00.

b. Yes, the transfer should take place. From

the viewpoint of the entire company, the
cost of transferring the units within the
company is P31.25, but the cost of
purchasing the special parts from the
outside supplier is P37.00. Therefore, the
companys profits increase on average by
P5.75 for each of the special parts that is
transferred within the company, even
though this would cut into production and
sales of another product.

The LM Company has two divisions,

Production
and
Marketing.
Production
manufactures designer pants, which it sells
both to marketing division and to other
retailers (under different brands). Marketing
operates many pants stores, and it sells
both LM pants and other brands. The
following data also pertain to LM Company:
Sales price to retailers if sold by Production is P380
per pair.
Variable cost to produce is P190 per pair.
Fixed costs is P2,000 per month.
Production currently operates below its capacity.
Sales price to customers if sold by Marketing is P500
per pair.
Variable marketing costs is 5% of sales price.

Marketing has decided to reduce the sales price

of LM pants. The companys variable
manufacturing and marketing costs are
differential to this decision, whereas fixed
manufacturing and marketing costs are not.
What

is the minimum price that Marketing can

charge for the pants and still cover differential
manufacturing and marketing costs?
What is the appropriate transfer price for this
decision?
What if the transfer price were set at P380?
What effect would this have on the minimum
price set by the marketing division?

Answers:
a.
b.

c.

Minimum Price = (190/ (100%-5%) = P200

The transfer price that correctly informs
the marketing manager about the
differential costs of manufacturing is P190.
Marketing would set a price in excess of
(P380/95%) P400. Even if the price is set
above P200, it will generate contribution
margin for the company.

The Domino Company has two decentralized divisions.

A and B Division. A has always purchased certain
units from Division B at P75 per unit. Because
Division B plans to raise the price to P100 per unit,
Division A desires to purchase these units from
outside suppliers for P75 per unit. Division Bs costs
follow:
Division Bs variable cost/unit
P70
Division Bs annual fixed costs
P15,000
Division As purchase
1,000 u
If Division A buys from an outside supplier, the
facilities Division B uses to manufacture these units
will remain idle.
Would it be profitable for the company to enforce the
P100 transfer price that to allow Division A to buy
from outside suppliers at P75 per unit?

Total purchase costs( P75x1,000 u)

P75,000
Total VC if purchase from Division B
(P70 x 1,000 units)
70,000
NET ADVANTAGE TO THE COMPANY
AS A WHOLE
P
5,000
It is therefore more profitable for the
company to enforce the P100 transfer price.