Question

Decision on transfer pricing

Materials used by the Instrument Division of XPort Industries are currently purchased from outside suppliers at a cost of $374 per unit. However, the same materials are available from the Components Division. The Components Division has unused capacity and can produce the materials needed by the Instrument Division at a variable cost of $310 per unit.

Assume that a transfer price of $355 has been established and that 25,400 units of materials are transferred, with no reduction in the Components Division’s current sales.

a. How much would XPort Industries’ total income from operations increase?
$

b. How much would the Instrument Division’s income from operations increase?
$

c. How much would the Components Division’s income from operations increase?
$

d. Any transfer price will cause the total income of the company to increase , as long as the supplier division capacity is used  toward making materials for products that are ultimately sold to the outside.

Answer 1

a). Increase in XPort Industries’ total income from operations = ($374 - $310) * 25,400 units = $1,625,600

b). Increase in Instrument Division’s income from operations = ($374 - $355) * 25,400 units = $482,600

c). Increase in Component Division’s income from operations = ($355 - $310) * 25,400 units = $1,143,000

d). Any transfer price will cause the total income of the company to increase, as long as the supplier division capacity is used toward making materials for products that are ultimately sold to the outside. However, transfer prices should be set between variable cost and selling price in order to give the division managers proper incentives. A transfer price set below variable cost would cause the supplier division to incur a loss, while a transfer price set above market price would result in loss to the purchasing division. Neither situation is an attractive alternative for an investment center manager. Thus, the general rule is to negotiate transfer prices between variable cost and selling price when the supplier division has excess capacity.