Question

Provide a detailed example explaining how transfer pricing can benefit the company as a whole, but the purchasing or selling department incurs a loss.

Answer 1

Take the following scenario shown in Table 1:

Here Division A makes components for a cost of $30, and these are transferred to Division B for $50 (shown as the transfer out price for Division A and the transfer in price for Division B). Division B buys the components in at $50, incurs own costs of $20, and then sells to outside customers for $90.

As things stand, each division makes a profit of $20/unit, and it should be easy to see that the group will make a profit of $40/unit. You can calculate this either by simply adding the two divisional profits together ($20 + $20 = $40) or subtracting both own costs from final revenue ($90 – $30 – $20 = $40).

You will appreciate that for every $1 increase in the transfer price, Division A will make $1 more profit, and Division B will make $1 less. Mathematically, the group will make the same profit, but these changing profits can result in each division making different decisions, and as a result of those decisions, group profits might be affected.

Consider the knock-on effects that different transfer prices and different profits might have on the divisions: