Question

Transfer Pricing
KingXY Ltd is organised on decentralized lines, with each manufacturing division operating as a separate profit centre.
The manager of a division has full authority to decide on sale of the division’s output to outsiders and to other divisions. Division Y has always purchased its requirements of a component from Division X.
But when informed that Division X was increasing its selling price to R300, the manager of Division Y decided to look at outside suppliers. Division Y can buy the component from an outside supplier for R270.
But Division X refuses to lower its price in view of its need to maintain its return on the investment.
The following information are also available: X’s variable costs per unit R240, X’s fixed cost per unit R40 and Y’s annual purchase of the component is 500 units

Required:
4.1 Will the company as a whole benefit, if Division Y bought the component at R270 from an outside supplier?     

4.2 If Division X did not produce the material for Division Y, it could use the facilities for other activities resulting in a cash operating savings of R20,000. Should Y then purchase from outside sources?
      

4.3 Suppose there is no alternative use of X’s facilities and the market price per unit for the component drops by R35. Should Y now buy from outside?    

4.4 The manager of Division X has been asked to vary the method used to determine the transfer price. However, she is not aware of the methods used to determine transfer price.
Briefly explain the various methods the manager of Division X could use to set the transfer price. Based on the circumstances, recommend which method can suit Division X.  

Answer 1

Ans 4.1
Assming that the Overall Fixed cost for KingXY will not
change based on the decision to procure the the component
from outside or from Div X.
So Fixed cost is not a relevant factor here, we need to look at the
variable cost difference to make the decision.
Cost benefit when Component purchased from outside
Annual Purchase of component by Y =500 units	Anount in R
Particulars	Dept X	Dept Y	Total
Savings of Variable cost per unit	240		240
Component buying cost from Outside/unit		(270)	(270)
Net benefit/Cost( ) per unit			(30)
So there is incremental cost of $30 /unit when the component or $15000 incremental cost per as a whole
annum when the component is bought from outside.
Therefore the company will not benefit as a whole in this case.

Ans 4.2
Cost benefit in the second case
Annual Purchase of component by Y =500 units	Anount in R
Particulars	Dept X	Dept Y	Total
Savings of Variable cost for the component @R240 for 500 units	120000		120000
Cash operating Savings Total	20,000.00		20000
Component buying cost from Outside@R270/unit for 500 units		(135,000)	(135,000)
Net Benefit/ Cost ( ) per year			5000
As there is $5000 net benefit in this case, the component can be purchased from outsid.

Ans 4.3
Cost benefit when there is not alternate use for X facility
Particulars	Dept X	Dept Y	Total
Savings of Variable cost per unit	240		240
Component buying cost from Outside/unit @R 235/unit		(235)	(235)
Net benefit/Cost( ) per unit			5
Net benefit for 500 units =5*500=2500
In this case there is benefit of $2500 per year , so the component can be procured from outside.

Ans 4.4

There are various methods of interdepartmental transfer pricing.

Some of the most used methods are Cost Plus basis , Market Price

based or Negotiated Price base.

In cost plus method an agreed mark up is applied over the

standard cost or variable cost or Actual full cost of the product

and that is considered as the transfer price.

In a market Price basis , an agreed price based on the arms length

price in a competitive market is taken as transfer price.

In negotiated price , the transfer price is based on the agreed and

negotiated price keeping in account the cost of production, the

required return of divisions, the price from alternate sources,

the cost benefit analysis of alternate opportunity costs etc.

In this case the negotiated price will be the best options as there

are manu situations with alternative options are coming up and

it will be better to negotiate and decide the best transfer price

keeping all the factors in consideration.